Stock – Interest rates may finally be getting real.
To investors with a sense of history, the near-zero and even negative interest rates of recent years might have seemed unreal, and indeed were unprecedented in the 5,000 years of recorded history of such matters. While the recent rise in bond yields has put rates back within the range of their historic norms, they are still under the level of inflation, anticipated or current, meaning that they’re negative in real terms.
This past week saw the benchmark 10-year Treasury’s real yield actually touch zero percent, something that hadn’t happened since March 2020. That was when the Federal Reserve initiated its hyperstimulative monetary policy, slashing short-term rates to almost zero and buying trillions in securities to pump liquidity into the financial system. With the central bank having just ended those emergency policies after some two years, the real 10-year rate finally has moved up from around minus 1%, where it was as recently as early March.
The concept of real interest rates was developed by economist Irving Fisher more than a century ago. The nominal rate quoted on an instrument consists of a real rate, plus the anticipated inflation over the instrument’s life. Expected inflation is reflected in the “break-even rate,” calculated by deducting the real yield on Treasury inflation-protected securities from the regular Treasury note’s yield.
For a while Tuesday, 10-year TIPS traded at a 0% real yield, while the 10-year Treasury was quoted at 2.93%, which means the anticipated break-even inflation rate was 2.93%.
Back on March 7, the 10-year note yielded 1.78% while the corresponding TIPS changed hands at negative 0.99%, for a break-even inflation rate of 2.77%. So, the recent jump in the Treasury yield was almost all in its real yield.
Positive real interest rates are associated with more-restrictive financial conditions, which is what the Fed is trying to promote to curb inflation. Negative real rates are almost a bribe to borrowers, who can invest money cheaply obtained in all manner of things, wise and otherwise, pumping up asset prices. The process works in reverse when real rates rise and turn positive.
Getting bond yields above expected inflation would mark a milestone, maybe one indicating a shift to a restrictive monetary policy, notes Ed Hyman, the perennially top-rated economist who heads Evercore ISI. But it’s more complicated, he explains in a phone interview.
Viewed the other way round, the federal-funds rate is even further below the Treasury bond yield, making policy very stimulative. “You’ve got to get bond yields and fed funds in the same neighborhood,” he says. Right now, they not even in the same ZIP Code, with fed funds—the central bank’s key rate—only a quarter of a percentage point above their pandemic policy floor, at 0.25%-0.50%, far below late Thursday’s 10-year yield of 2.91%.
The real rate (negative 0.13% Thursday, down from 0% earlier in the week), while up nearly a full percentage point in about six weeks, is still way below the most recent reading on the consumer price index, which soared by 8.5% in the 12 months ended in March. Based on that current “spot” inflation rate, rather than the TIPS break-even, the real 10-year yield is still deep in negative territory, at about minus 5.6%, according to Jim Reid, head of thematic research at Deutsche Bank.
Given that vast gap, he’s skeptical of the bond market’s prediction of future inflation around 3%. “I’m still not convinced inflation falls anywhere near enough over the next couple of years for real yields to get anywhere near positive,” he writes in a research note. More likely, they remain negative, owing to “financial repression” by central banks. If real yields do rise (more likely from higher nominal yields than from inflation receding faster), he warns, “run for the hills, given the global debt pile,” with a potential explosion in debt-servicing costs.
Most people aren’t rational enough to analyze all that, argues Jim Paulsen, chief investment strategist at the Leuthold Group, so he doesn’t think real yields matter so much. And, he adds in a phone interview, low or negative real yields usually are associated with weak growth and poor confidence, so they might not stimulate the economy. Indeed, if people see yields moving back up, it may restore a sense of normality and boost confidence.
For the stock market, he finds that nominal rates mean more than real yields. And the key tipping point is when the benchmark 10-year Treasury yield crosses 3%, as it appears poised to do.
Since 1950, when this yield has been below 3%, stocks have done fine. But they’ve fared worse when it was higher (and still worse when it topped 4%). When the yield was under 3%, equities’ annualized monthly returns averaged 21.9%, versus 10.0% when yields were higher, according to Paulsen’s research. In addition, volatility was lower (13.5% versus 14.6%), while monthly losses were less frequent (occurring 27.6% of the time, versus 38.2%). More to the point, there was only one bear market when the yield was below 3% during the period studied, but 10 when it was over that level.
Hyman worries that when the fed-funds rate and the bond yield do get closer, there could be a financial crisis. How bad a crisis? He notes that, in 2018, when the Fed was raising the funds rate while shrinking its balance sheet, the S&P 500 fell 20% late in the year. Then, Fed chief Jerome Powell pivoted, declaring that he would be “patient” about further rate hikes; he wound up cutting rates in 2019.
Not all financial crises lead to economic downturns. In a client note, Hyman lists episodes of Fed tightening that precipitated what he terms crises without causing a recession. Prominent among them is 1994, when the central bank doubled the funds rate, to 6% from 3%, in short order. What followed was a rout in the mortgage-backed securities market; the bankruptcy of Orange County, Calif., whose treasurer had speculated in financial derivatives; and the Mexican peso crisis that resulted in a $50 billion U.S. bailout. However, there would be no recession for the rest of the century.
So how serious is the threat from a real bond yield that’s no longer negative? Start to worry when the Fed lifts its fed-funds target close to that of the bond yield. But, as Hyman observes, Powell & Co. “have a lot of wood to chop” before that happens.