The pieces are in place for ASX stocks to keep rallying into 2021, but there's one risk factor that's been slowly creeping up on investors.
Before I delve into that, don't call me a pessimist. If anything, I am expecting the new year to be good for the S&P/ASX 200 Index (Index:^AXJO).
Money is cheap and economic growth will be "forced" to rebound. I say forced because 2020 has set such a low bar that we can almost certainly bank on better growth rates in 2021.
Rising yields a red flag for 2021
While I am feeling upbeat, I have been watching the yield on the US 10-year government bond rising in the background.
I think this government bond (called Treasury) could derail the share market rally. For those who can remember the time before COVID‐19 dominated our entire existence, a jump in the 10-year Treasury yield triggered a share market sell-off.
The yield on the 10-year has nearly doubled since August this year to around 0.93%. This is despite the US Federal Reserve's commitment to keep buying Treasuries to keep yields and borrowing costs low.
10-Year Treasury Yield Close to Doubling in Four-Months
Source: Marketwatch.com
Why ASX investors should watch the 10-year Treasury yield
Everything is priced off the 10-year Treasury, which is used as the "risk-free" benchmark in valuing assets.
All things being equal, the higher the risk-free yield, the lower the valuation for stocks. I don't believe global equities have priced in this risk, and many experts in Australia may not be even paying attention.
I say this because the 10-year Australian government bond hasn't really moved over the past six-months even as its US counterpart jumped. The Reserve Bank of Australia is doing an excellent job in holding back Aussie bond yields.
Where Treasuries go, the Aussie follows
While that works in the shorter-term, it may not over a longer-period. The Aussie 10-year has historically followed the 10-year Treasury for good reason. The question is how long can the hold the fort.
This is why investors should be keeping an eye on this, especially since Treasury yields could rise further in 2021.
This is in part driven by inflation expectations. The "breakeven" rate in the US jumped to 1.99% this year – a two year high, reported Bloomberg.
The breakeven is a key market measure on future inflation expectations, and there are several reasons why investors are expecting prices to rise.
Why bond yields could rise further in 2021
The surge in commodity prices is one clear inflationary signal. The change in US presidents is another as Biden is likely to pump more stimulus into the COVID-hit economy.
To be sure, I am not concerned about inflation as having some price pressure is good news when it's accompanied by economic growth.
The thing I am more concerned about is the impact the risk-free rate will have on the ASX, especially at a time when stocks look priced for perfection.
By all means stay long on stocks for 2021 – just don't get caught with your pants down.
