Falling Real Yields Key to Market Recovery: What Investors Need to Know

Meet the force behind TINA – the popular acronym among traders for the idea that “there is no alternative” to stocks.

Real, or inflation-adjusted, yields on safe government bonds have remained consistently negative despite rising inflation, contributing to continued demand from yield-hungry investors for stocks and other assets perceived to be risky.

The concept is simple. “The lower real yields fall, the better other assets are relative” to bonds, said Joe Kalish, chief global macro strategist at Ned Davis Research, in a telephone interview.

And they certainly fell. The real yield on 10-year Inflation-Protected U.S. Treasuries, or TIPS, hit an all-time low of -1.196%, based on data going back to 2003, on November 9, and remained unchanged. this level since, according to Tradeweb, closing Friday at -1.136%.

The phenomenon, in the face of mounting inflationary pressures, presented something of a headache for investors and analysts. Kalish previously dubbed negative real returns “the biggest headache of fixed income.”

The strategist put together some of these pieces of the puzzle in a November 16 memo, identifying three main drivers of negative returns:

  • Investors looking for inflation protection have crowded into TIPS. After all, TIPS are the only way for investors to hedge directly against inflation because their principal amount automatically adjusts for CPI inflation. The Federal Reserve, of course, is also a buyer of Treasuries, helping to keep a lid on nominal yields.

  • At the same time, the Fed has also stocked up on inflation-protected securities. The central bank owns 22% of all TIPS in circulation.

  • The relentless demand for Treasuries from foreign buyers is limiting nominal yields despite rising inflation. US nominal yields remain well above those of bonds in Europe, the UK and Japan. US debt looks more attractive even after hedging currency risk.

Negative and falling returns have certainly been accompanied by rising equity valuations and strong returns.

In a November 1 note, Lori Calvasina, equity analyst at RBC Capital Markets, reviewed the performance of the S&P 500 SPX stock index,
-0.14%
since the 2008 financial crisis, comparing it to actual returns.

“On a 3, 6 and 12 month forward looking basis, stock market returns have been much higher when real returns are falling and negative than when they are rising and positive,” Calvasina said (see chart below).

RBC Capital Markets


“It also helps explain, in our opinion, why the US stock market has been more resilient than some had anticipated lately in the face of what looks like a relentlessly negative news feed.”

Kalish looked at the future returns of companies in the S&P 500 and Nasdaq-100 NDX, a heavy-tech,
+ 0.55%,
by comparing them to real 10-year Treasury yields. He found that a rising spread resulted in stocks outperforming their historical performance, while a falling spread caused an underperformance. Falling real returns would widen the spread, while rising real returns would narrow it.

The difference in annual gain for the S&P 500 was around 4 percentage points, he said, and nearly 6 percentage points for the Nasdaq-100.

Indeed, the relationship between real returns and tech stocks is particularly strong, Kalish said, and has grown stronger since the Fed adopted looser monetary policy in 2019. Technology and other equity-focused stocks Growth are sensitive to fluctuations in interest rates because their valuations are based on expectations of earnings growth and cash flow.

This means technology stocks and growth-oriented stocks could be particularly vulnerable if real returns start to rise, Kalish said.

On the flip side, an index of large cyclical stocks tends to be positively correlated with real returns – rising and falling together, the analyst noted.

Outside of stocks, the inverse relationship between gold and real returns also stands out, with the yellow metal rising when real returns fall and decreasing when real returns rise.

“Since the GFC (great financial crisis) it seems that only the direction of real returns matters for gold,” he said.

And then there is the bitcoin BTCUSD,
+ 0.23%,
which struggled from its peak in late 2017 until late 2018 – a period that was largely accompanied by rising real returns, Kalish noted. He found that bitcoin has risen 180% per year when real returns fall from a still quite respectable but much lower figure – by several orders of magnitude – of 37% when real returns are on the rise. .

All of this speaks to the attention investors need to pay to the Fed and other central banks. The Fed is starting to cut its monthly bond purchases this week, on a schedule to end the program by June.

Investors have increased bets that the Fed will act quickly to start raising their key interest rates once the cut is over. A flattening of the yield curve as short-term rates rise faster than longer-term rates in anticipation of Fed action, some investors cite potential for policy error, policy tightening monetary triggering an economic slowdown.

Kalish argues that the curve is sending a more favorable signal, reflecting expectations that the Fed will act in time to curb inflation. There would be a danger, however, if the Fed ended up delaying its timetable.

“If the Fed and other central banks were to raise rates and start raising real yields, it could create headwinds for some of these other asset classes,” Kalish said.

Investors will analyze the minutes from the Fed policy meeting on November 2-3, when released at 2 p.m. EST on Wednesday, a day packed with U.S. data that will also include jobless claims. weekly, the duration of October. merchandise orders, consumption and personal spending data and other releases ahead of the Thanksgiving holiday Thursday, when U.S. markets are closed.

The Nasdaq Composite COMP,
+ 0.40%
closed at a record 16,057.44 on Friday, up 1.2% for the week. The Dow Jones Industrial Average DJIA,
-0.75%
suffered a second consecutive weekly loss, down 1.4%, while the S&P 500 lost 0.3%. The Dow is 2.4% below its closing high on November 8, while the S&P 500 is just 0.4% off its high on Thursday.

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