July 2, 2013
The Rise Of Real Yields
It was obvious as far back as this past April that the positive connection between stocks and the Treasury market's inflation forecast in recent years was coming apart. As the weeks rolled on and the divergence persisted, it was also clear that the break signaled a substantial change in the macro-market outlook. Exactly what was changing wasn't conspicous early on, but it now appears that we're finally at the point of transitioning to something approximating normality. It's been a long time coming. It looks like the end of the world to some, but the apocalyptic narrative in this case is one more overbaked view of the future until the numbers tell us differently.
Yes, there are caveats, as always. But for now, there are signs of stabilization. That starts by noting that inflation expectations (defined by the yield spread between the 10-year Treasury and its inflation-indexed counterpart) are no longer falling, which is a good thing. But that's only been true for the last few trading sessions and so any final conclusions remain premature. That said, the stock market has perked up over the past week, rising a bit after stumbling for most of the past month or so.
As we wait for the full profile of July's revelations, it's important to recognize that the decline in inflation expectations has been fueled by a sharp rise in both nominal and real yields, with the latter jumping rather dramatically. Whereas the yield on the conventional 10-year Note is up around 60 basis points since the end of March, the inflation-indexed 10-year Note yield has jumped by nearly twice as much, surging more than 110 basis points to just under 0.5% as of yesterday.
For the first time in more than a year, the real yield on a 10-year inflation-protected Note (TIPS) is positive. And at roughly 0.5%, yesterday's real yield is the highest in about two years. It's easy to explain the jump in real yields as a function of panic selling, which to some extent is true. But over longer stretches of time we should expect to see the real yield echo real economic growth.
Using the latest GDP numbers, the US economy grew at a real, seasonally adjusted annual rate of 1.8% in this year's first quarter. That's a sluggish pace, but it hardly implies a negative real yield on the order of -50 to -100 basis points, which is the range that prevailed late last year and into the early part of 2013. If you were expecting the economy to fall into recession, the persistence of negative real yields looked reasonable. But as I've shown for some time (including this mid-June update), recession risk has remained low. Modeling the outlook for second-quarter GDP, by the way, suggests more of the same.
In turn, that analysis suggests that fairly steep negative real yields were destined to rise. True, the catalyst for the recent surge in real yields is widely attributed to the Federal Reserve's chatter about tapering monetary stimulus. But that doesn't alter the fact that real yields have been too low based on the broad trend in the economy.
Some analysts warn that we're slipping into the end game of macro comeuppance and so the economy and the markets must pay for sins incurred over the past several years, i.e., the central bank's monetary stimulus. But rather than analyzing macro as a morality play, I prefer to see all the volatility as a renewed effort to find equilibrium and price assets for what continues to be the primary narrative: modest growth.
In this scenario, the stock market and inflation expectations won't be joined at the hip (at least not so tightly) and so the two price series will exhibit more independence. That's a step toward normalizing the macro-markets dance. It won't always be pretty and the transition will take time. But this paradigm shift, if we can call it that, was always inevitable. Yes, we're probably still in the early stages of this switch. The first round was rather violent, but that's unlikely to persist. The evolution ahead may bring more volatility at times as the crowd is forced to grapple with change, but a kinder, gentler transition is probably coming.
And let's be clear: this evolution will be productive, even if it means temporary disruptions to easy profits from time to time. Indeed, the past five years have been abnormal. The next five are likely to be less so.
Posted by jp at July 2, 2013 5:34 AM