By Jamie McGeever
ORLANDO, Fla. – The specter of higher inflation, interest rates and bond yields usually spells trouble for stocks. But Wall Street continues to scale new peaks, driven by the increasingly entrenched phenomenon of sub-zero real yields.
The inverse relationship between the fall in U.S. Treasury Inflation-Protected Securities’ ‘real’ yields to record lows and major U.S. equity indexes grinding to new highs has strengthened substantially in the last six months.
It has been one of the few constants as Wall Street has hurdled several obstacles it might normally stumble on: historically high inflation and inflation expectations; the Fed tapering and preparing to raise rates; spiking bond market volatility; flattening and even inverted yield curves.
Long-held priors about these relationships are being questioned, and the stakes could not be higher: U.S. inflation is the hottest in over 30 years, the Fed still thinks it is “transitory”, but pressure on policymakers is intensifying.
There are bumps in the road, but equity markets march on. Low long-term bond yields lower the discount rate that’s used to value companies’ future cash flows in today’s stock price – any backup in the discount rate redraws the map for equity along with the damage from related tightening of credit.
While real yields may push back higher as central banks prepare to tighten, few see them turning positive for a long time. Gargi Chaudhuri, head of iShares investment strategy at Blackrock, says we are in a “new environment” in which the old assumptions that rising interest rates and nominal bond yields are bad for equities has to be challenged.
“More importantly for equities, real yields will become a problem if they enter restrictive territory,” she says, adding that this is unlikely to happen for two to three years.
Meghan Swiber, rates strategist at Bank of America, reckons 10-year real yields could remain negative for around 10 years. Analysts at Morgan Stanley published a similar forecast earlier this year.
FADE AWAY
Inflation-adjusted yields on TIPS have diverged from yields on conventional Treasury bonds in recent months. The difference between the two, the ‘breakeven’ rate and a closely-watched measure of inflation expectations, has risen sharply.
The fall in real yields is in some ways unsurprising, given the scramble from investors for inflation protection. In fixed income, TIPS and related investment vehicles such as TIPS exchange-traded funds, are in huge demand.
The 10-year U.S. TIPS yield has been deeply negative all year. After a notable rise at the end of the first quarter, it has slumped back, hitting a new low of -1.24% this week. Although still low by historical standards, the nominal 10-year yield has risen 65 basis points this year.
Strategists at Blackrock and Bank of America both say demand for TIPS ETFs has been “incredible”, from investors wanting a short-term inflation hedge and others adding inflation protection into their longer-term asset allocation strategy.
To the extent that real rates stay negative, growth remains above trend, consumer spending holds up and companies are able to pass on higher costs to their customers, equities could continue to perform reasonably well.
The S&P 500 has made 65 new all-time highs in calendar year 2021, the second most ever and only 12 away from the record of 77 set in 1995.
Third quarter earnings were solid: 80% of S&P 500 companies beat forecasts, with that rising to 93% for the tech sector. Valuations are still high, but don’t appear to be prohibitively so just yet.
Markets may be entering a critical period though if the Fed struggles to convince investors – and even itself – that it can wait until its taper schedule is over around the middle of next year before raising rates.
And TIPS are expensive. Can real yields really go any more negative? Maybe, if Britain is any guide. The 10-year inflation-linked gilt yield is below -3.0% and has been sub-zero for a decade.
Oliver Allen, markets economist at Capital Economics, believes real yields’ sway over Wall Street will gradually fade as elevated inflation forces the Fed to tighten policy in real terms.
“The tailwind of falling real yields turning into a modest headwind is one reason why we think U.S. equities will struggle to make gains over the next couple of years,” Allen says.
(By Jamie McGeever)
