Investors say negative real yields are driving the ‘everything rally’
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A collapse in real yields — the return that bond investors can expect once inflation is taken into account — is rippling through global financial markets and driving record rallies in assets from gold to technology stocks, investors say.
The yield on 10-year inflation-linked US government bonds, known as Tips, sank below minus 1 per cent last week to a historic low, as investors bet that a surge in coronavirus cases would prolong the damage to the world’s biggest economy — and that the Federal Reserve’s efforts to stimulate demand could stir inflationary pressures.
The deeply negative Tips yield implies that large chunks of the Treasury market are expected to lose investors money, in real terms, over the next decade. Sub-zero real yields have long been a feature of the landscape in Japan, the eurozone, and the UK. But the shift in the US — the last bastion of positive real returns on safe assets — is showing up in all corners of the financial markets.
“There isn’t an interest rate anywhere in the world that looks attractive once you take inflation into account,” said David Vickers, a multi-asset portfolio manager at Russell Investments. “That makes just about everything else seem more appealing.”
Tumbling real yields help explain the remarkably strong stock market recovery from the coronavirus-triggered crash in March, according to some analysts and investors.
“Many investors have underestimated the impact of low yields on valuations,” Howard Marks, the founder of Oaktree Capital Management, wrote in a letter to his clients this week.
Negative real yields are also seen as a factor in gold’s record rally. Investors like Mr Vickers have been buying the precious metal as a hedge for the riskier assets in their portfolios, on the view that government bonds have little room to appreciate if stocks decline.
The real-terms loss offered on most high-rated government debt makes the lack of income offered by gold — as well as silver — less of a drawback. This logic helped propel the nominal price of gold above $2,000 a troy ounce for the first time this week.
The ingredients of 2020’s bond rally are unusual. A rise in break-evens — the gap between real yields on inflation-linked bonds, and nominal yields, which serves a proxy for investors’ expectations of inflation — is typically associated with a brightening of the economic outlook. It also tends to coincide with a sell-off in nominal government bonds, because their fixed returns are eroded over time by price rises.
But this year, government bond prices around the world have risen, despite a sharp pick-up in inflation expectations in recent months.
“Beneath the apparent tranquility of flatlining nominal yields in government bond markets in recent weeks, there has in fact been a remarkable rally — not only matching that in risk assets but in many respects exceeding it,” said Matt King, global head of credit strategy at Citi.
For Mr King, this shift cuts to the heart of markets’ “QE addiction”, in which ever greater levels of Fed stimulus are required just to prevent risky assets from falling.
Investors say this is triggered by the combination of massive monetary and fiscal stimulus. Central banks’ bond-buying programmes have allowed for unprecedented levels of cheap borrowing. Fund managers are now betting that policymakers will keep the stimulus tap running, even if inflation picks up.
Seamus Mac Gorain, head of global rates at JPMorgan Asset Management said the co-ordination in fiscal and monetary interventions has been “so much more powerful than the policies we saw after the global financial crisis, when central banks had to do all the heavy lifting”.
The Fed is likely to promise to hold short-term interest rates close to zero until inflation is sustainably above target, Mr Mac Gorain said. He thinks that still makes Tips an attractive bet, with real yields likely to sink closer to minus 2 per cent.
The plunge in real yields is certainly not a sign of an imminent panic over price rises. Long-term inflation expectations have risen sharply but remain low by historical standards. Ten-year break-evens in the US, at around 1.5 per cent, are well below the Fed’s target. For now, many investors are far more preoccupied by the possibility of falling prices in the Covid downturn.
But further down the line, some fund managers worry it will be tough for policymakers to pull back on stimulus, potentially fuelling a period of much higher inflation that could finally end a four-decade bull market for bonds.
“Once politicians have seen how great it is to have all this cheap money, they’ll find it difficult to wean themselves off,” said Pilar Gomez-Bravo, director of European fixed income at MFS Investment Management.
In the meantime, it also means that stock market valuation metrics themselves are likely to be acutely sensitive to shifts in inflation expectations — and lead to more volatility, according to Jordi Visser, chief investment officer of Weiss Multi-Strategy Advisers, a hedge fund. “In a world with negative real rates, the booms and busts will be faster,” he said.
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