COLUMN-Wall Street dancing to real yield tune amid inflation mood music: McGeever

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(The views expressed here are those of a columnist writer for Businesshala.)

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ORLANDO, Fla., Nov 12 (Businesshala) – The specter of high inflation, interest rates and bond yields generally spell trouble for stocks. But Wall Street continues to scale new peaks, driven by an increasing incidence of sub-zero real yields.

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The inverse correlation between record lows in the ‘real’ yields of US Treasury inflation-protected securities over the past six months and major US equity indices hitting new highs has strengthened significantly.

It has been one of the few constants since Wall Street has barred several hurdles it can usually stumble upon: historically high inflation and inflationary expectations; Fed preparing for tapering and raising rates; spiking bond market volatility; Flattened and even inverted yield curve.

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These relationships are being questioned by long-held priests, and the stakes couldn’t be higher: US inflation at the hottest in more than 30 years, the Fed still thinks it’s “temporary,” but The pressure on policy makers is mounting.

There are bumps in the way, but equity markets move on. Lower long-term bond yields lower the discount rate used to value companies’ future cash flows at today’s stock price — any backup in the discount rate with losses from the associated tightening of credits. -With redraws the map for equity.

While real returns could push back higher as central banks prepare to tighten, some see them turning positive over the long term.

We are in a “new environment” in which to challenge the old notion that rising interest rates and nominal bond yields are bad for equities, says Gargi Choudhary, Head of iShares Investment Strategy at BlackRock.

“More importantly for equities, if they enter restrictive territory real returns will become a problem,” she says, adding that this is unlikely to happen for two to three years.

Bank of America rate strategist Meghan Swiber believes the 10-year real yield could remain negative for about 10 years. Morgan Stanley analysts published a similar forecast earlier this year.

fade away

Inflation-adjusted returns on TIPS have diverged from yields on traditional Treasury bonds in recent months. The gap between the two, a closely watched measure of the ‘break even’ rate and inflation expectations, has grown sharply.

The fall in real returns is in some ways surprising, given investors’ scramble for inflation protection. In fixed income, TIPS and related investment vehicles such as TIPS exchange-traded funds, are in huge demand.

The 10-year US TIPS yield has been very negative throughout the year. After a significant rise at the end of the first quarter, it has fallen back to a new low of -1.24% this week. Although still low by historical standards, the nominal 10-year yield rose 65 basis points this year.

Strategists at both BlackRock and Bank of America say the demand for TIPS ETFs has been “incredible,” with investors seeking a short-term inflation hedge and others adding inflation protection to their long-term asset allocation strategy.

To the extent that real rates remain negative, growth remains above trend, consumer spending persists and companies are able to pass on higher costs to their clients, equities can continue to perform reasonably well.

The S&P 500 made 65 new all-time highs in calendar year 2021, the second-highest ever and just 12 away from the record 77 set in 1995.

Third-quarter earnings were solid: 80% of S&P 500 companies beat forecasts, rising to 93% for the tech sector. Valuations are still high, but don’t seem prohibitively yet.

The market may be entering a critical period, though if the Fed struggles to convince investors — and even itself — that it may wait until next year before raising rates. Its taper schedule should not end in the middle of.

And tips are expensive. Could the real return really be 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, market economist at Capital Economics, believes the dominance of real yields on Wall Street will gradually fade as increased inflation forces the Fed to tighten policy in real terms.

“The tailwind of a modest decline in real yields is one reason we think US equities will struggle to turn a profit over the next few years,” says Allen.

by Jamie McGyver


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