By Michael Lebowitz
Investors watch CNBC and CNBC’s competitors for guidance on where the markets are headed. CNBC can provide insightful commentary from highly qualified investors. Still, if one is watching CNBC to find out where the markets are headed, they may be better served to turn off the TV and look to the bond market for direction.
Today, real yields, or bond yields minus inflation expectations, help explain the movement of many assets. If we want to form reasonable expectations for stocks, commodities, the dollar index, and gold prices, it’s best to have an opinion about where real returns are headed.
In this article, we share evidence supporting the recent strong relationship between real returns and risk assets. Then, let’s think about where the actual returns are headed to help save you the confusion of trying to follow the conflicting bull and bear opinions presented on CNBC.
What are real returns?
Real return is the return an investor expects to receive after inflation. Think of it as the amount of purchasing power a bondholder expects to gain or lose. The inflation figure in the calculation is based on inflation expectations which are a by-product of the difference between TIP yields and nominal yields.
In a free market, lenders should be compensated for lending money. The compensation in the form of an interest rate should encompass the risk of non-repayment, the opportunity cost of not having the money available and expected inflation.
The focus of this article is primarily inflation, but risk and opportunity costs are also high.
What do real returns tell us?
The chart below shows real five-year Treasury yields since 2005. The current real yield is 1.62%, the highest level since 2009. From January 1, 2022, the real yield it has increased by 3.2% (from -1.58% to +1.62%). The composition of change is important. Since the beginning of the year, inflation expectations have fallen .55%, while nominal bond yields are 2.65% higher.
The level of real interest rates is a strong indicator of the weight of Federal Reserve policy. If the Fed is treading lightly and not distorting markets, real rates should be slightly positive. The more the Fed manipulates the markets from their natural rates, the more negative real rates become. –The Fed’s Growing Gold Footprint
Real yields provide a durable indicator that helps quantify the degree of Fed complacency or hawkishness. Today, the Fed is incredibly hawkish, judging by real yields.
Risk assets vs. real returns
Before we share our expectations about where real returns might be going forward, it’s worth pointing out the strong recent relationship between real returns and risk assets.
stocks
The Fed’s actions to stop inflation, including raising interest rates and QT, reduce liquidity in financial markets and the economy. Consequently, they are not beneficial for stock prices. When considering equity allocations, what matters is the degree to which they implement monetary policy.
The chart below shows that the recent rise in real yields is like the sharp jump in October 2008. At that time, the financial system collapsed and the Fed introduced QE. In a matter of months, inflation expectations went from +2.70% to -2.40% and back to zero percent. Nominal yields fell sharply over the period.
The current rise in real yields is mainly due to rising nominal yields and less to inflation expectations. Consequently, rising real yields will be much more damaging to the economy than the last time real yields were at similar levels.
The chart below shows the strong inverse correlation between real returns and stock prices this year. The Y-axis of the chart relative to actual returns is in reverse order to better highlight the relationship. The Fed is aggressively removing liquidity, and unsurprisingly, stocks are falling.
dollar
The US dollar has risen against all currencies this year. Recently, the link between dollar strength and bond weakness has been pronounced.
The chart below shows the strong correlation between the dollar and real yields this year. The Fed is employing the most aggressive monetary policy of any developed nation. This policy should keep the dollar well up, without central banks intervening in currency markets.
Merchandise
Commodity prices and the dollar tend to be negatively correlated, as the majority of global commodity trade occurs in US dollars. When the dollar is strong, commodity prices tend to weaken and vice versa.
Given the strong relationship between the dollar and real yields, the inverse relationship of commodities to real yields is expected. As we did in the S&P 500 chart, the Y-axis of the chart relative to real returns is in reverse order.
gold
Previously, we shared a paragraph from the Fed’s ever-growing gold footprint, which discusses how real yields are a barometer of the Fed’s monetary policy. In particular, the article discusses the strong inverse correlation between gold and real returns, especially when real returns are negative.
The reason is that gold prices are largely driven by monetary policy. Gold tends to trade well when the Fed is dovish and pushes real yields below zero. Real yields should never be below zero as lenders are being penalized for lending. Therefore, negative real yields point to too easy monetary policy. Since many see gold as a substitute for money, anything that decreases the value of money is good for gold. Conversely, gold fares poorly when the Fed is hawkish and a better steward of money.
Gold started the year well, rising around 10% as inflation picked up and the Fed was relatively accommodative. Real yields rose as the Fed grew increasingly hawkish and the inverse correlation between gold and real yields grew strong.
The million dollar question
After seeing the evidence, you must think that correctly forecasting actual returns is the holy grail of investing. Although it seems that way today, relationships change. That said, let’s consider where the real returns might go.
As we have shown above, the change in real yields is due to lower inflation expectations and much higher nominal yields. Over longer periods, nominal returns are a function of economic growth and inflation expectations. Given that high rates are and will continue to be a drag on economic growth and hold back inflation, we believe nominal and real yields will move lower over the coming months.
The current real yield on a five-year Treasury note is 1.62%. Over the past 20 years, the actual real yield achieved on five-year notes has averaged 0.47%. As a result, five-year yields may be trading more than 1% too high.
The Fidelity scatterplot below shows weekly levels of the ten-year UST yield and 5×5 inflation expectations. The 5×5 inflation expectation is the five-year implied inflation rate expected in five years. The current 5×5 inflation rate is 2.28%, similar to the current five-year implied inflation rate of 2.18%. As the chart shows, the current ten-year yield of 3.68% is 1.33% above the trendline rate of 2.35%.
We took Fidelity’s analysis a step further and compared the ten-year rate to the average of the five-year implied inflation rate and the 5×5 inflation rate. This method collects all ten years of inflation expectations. Since 2010, the Treasury bill has averaged 0.21% above the expected inflation rate. Currently, it is 1.40% above. Bond yields are more than 1% too high based on inflation expectations.
Summary
CNBC analysts make all kinds of predictions. But for our precious time and money, we prefer to turn off CNBC and consider that the future direction of returns may be the best investment advice today.
The US economy will not function with 7% mortgage rates. The Fed can keep raising rates, but the economy will falter. With this, inflation will decrease. Nominal yields would have to fall precipitously to catch up with inflation and growth fundamentals. Real returns should follow. If so, the outlook for stocks, bonds, gold and commodities may be brighter than it has been. Conversely, recent dollar strength may be close to peaking.
We end with the closing paragraph of Yesterday’s Returns Defy Logic.
Proven and trusted relationships are bad bond investors. Although powerful and troubling, we think of abnormal relationships as temporary. When the supply and demand for bonds normalizes, bond investors will likely find that economic, inflation and other factors warrant much lower yields.
