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Investors looking to blame the stock market’s recent wobble on rising Treasury yields might want to look a little deeper.
While the 10-year Treasury yield’s TMUBMUSD10Y, -0.53% upward march toward 3% is attracting attention, analysts say risky assets like equities aren’t responding to higher nominal bond yields, but are instead taking their cue from the rise in “real,” or inflation-adjusted yields. The real yield is the difference between the advertised yield on a bond and expectations for future inflation.
“Real rates are now at a point where further…increases will impinge on risky asset market performance in the absence of economic data that meets or beats elevated expectations,” said Matthew Hornbach, global head of interest rate strategy for Morgan Stanley, in a note earlier this week.
On several gauges, “real” yields have risen to their highest levels in several years. The 5-year real yield rose to 0.74%, double what it was at the beginning of the year. While, the 10-year real yield rose more than 30 basis points to 0.82% in 2018, its highest since Dec. 2015, but well below pre-2008 levels, as the chart below shows.
Real yields have swung higher, but are historically subdued
Usually, rising real rates wouldn’t be a problem for risk assets. Stocks tend to rise along with real rates as growth expectations heat up. But analysts are sounding the alarm over the fiscal boost provided by recently enacted tax cuts and other measures at the same time the economy is nearing full employment.
The Trump administration on Monday laid out a $4.4 trillion budget plan that projects deficits over the next decade. While the budget has little chance of being enacted as is, it offers a window into the president’s priorities. It also comes after the White House and congressional leaders agreed to a two-year budget deal that would boost federal spending by $300 billion.
Meanwhile, economic data has disappointed and real yields for government paper proceeded to climb. The Citi economic surprise index, which measures on average how much a data point deviates from analysts’ forecasts, has slid this year to 40.50 on Feb. 13 from a high of 80.70 on Jan. 4, according to FactSet data.
Stocks started to encounter turbulence as real interest rates became increasingly unmoored from the underlying economy (see chart below). In other words, borrowing costs were outstripping growth and inflation, potentially eating into corporate profits and unnerving a stock market used to cheap credit and low interest rates, said Hornbach.
Stocks began to decline as real yields headed higher
The S&P 500 SPX, +0.57% and Dow industrials DJIA, +0.50% last week slumped into correction territory—pulling back more than 10% from all-time highs set in late January—but have taken back a chunk of lost territory this week.
Investing luminaries, including Ray Dalio, the founder of Bridgewater, the world’s largest hedge fund, have weighed in on the rise in real yields. Dalio said he was interested to see how the Federal Reserve would react to the fiscal stimulus amid dwindling slack in the economy.
“There is a whole lot of hitting the gas into capacity constraints that will lead to nominal rate rises driven by the markets. The Fed’s reactions to them and the amount of real (inflation-adjusted) rate rises that will result will be very important, so we will be monitoring this closely,” Dalio said in a LinkedIn post.
Rising real yields might also reflect expectations for choppy waters ahead. The real yield is viewed by bond investors as the cushion, or premium, against the ravages of inflation and monetary policy uncertainty.
“You wind up needing a greater return as there’s a potential for more erosion from what you get,” said Marvin Loh, senior fixed-income strategist for BNY Mellon.
And with fiscal stimulus arriving when the economy is near full capacity, a resurgence of inflation could throw a wrench into the Federal Reserve‘s preference for tightening monetary policy at a slow and steady pace.
“Higher real yields are a clear sign that the monetary tightening that is already under way is set to continue,” said analysts at BMI Research.
That wasn’t a problem when a Janet Yellen-led Fed hiked interest rates three times last year even when inflation was absent. The Citi inflation surprise index has been negative since March, an indication that above-than-expected price readings have been few and far between.
“We didn’t need as much compensation for surprise inflation numbers, the Fed was ahead of the game, inflation wasn’t showing itself,” said Loh.
The consumer-price index number for January underlined concerns a period of muted price pressures could be coming to an end. Stripping out volatile food and energy prices, the core gauge rose 0.3%, the strongest one-month increase since March 2005.
As inflation nudges back toward the Fed’s 2% target, the challenge of tightening policy without stalling the economy’s momentum has revealed divisions within the central bank’s rate-setting Federal Open Market Committee, said Charlie Ripley, senior investment strategist for Allianz Investment Management.
San Francisco President John Williams said he would not support a more aggressive pace of rate increases. Cleveland Fed President Loretta Mester said the central bank should stay the course and keep raising rates.
This debate is also playing out as the central bank witnesses a changing of the guard. Fed Chairman Jerome Powell, sworn in last week, begins his tenure with several vacancies on the Fed’s Board of Governors yet to be filled.
But investors shouldn’t get carried away by the steady climb in real rates. Strategists at J.P. Morgan said the stock market has rarely seen a downturn when real yields were below 2%.
“It’s still hesitant, real yields have adjusted to reflect a greater risk of inflation, but it’s still not saying that its back to normal,” said Loh.