Fed sends US real yields to the edge of positive territory
Rise in inflation-adjusted government bonds is the latest headwind for risky assets
Inflation-adjusted bond yields in the US are on the verge of turning positive for the first time since March 2020, putting further pressure on riskier areas of financial markets.
So-called 10-year real yields have risen more than 1 percentage point since early March, topping a minus 0.05 percent on Monday, in a sign that bond payouts are nearly beating inflation expectations.
The surge in real yields was prompted by the Federal Reserve's efforts to curb strong inflation by aggressively tightening monetary policy. The move is already undermining one of the pillars that have supported a powerful rally in equities and riskier corporate bonds since the coronavirus crisis bottomed out two years ago.
"The Federal Reserve will withdraw liquidity," said David Lefkowitz, head of US equities at UBS's chief investment office. "It's the more speculative parts of the market that benefit most when the Fed injects liquidity, and they [could] face headwinds if the Fed goes the opposite way and pulls back."
The plunge in real ultra-low-risk US Treasury yields into negative territory in 2020 has prompted investors to scramble for assets that could yield higher yields once inflation effects are factored in. As a result, loss-making start-ups and fast-growing tech companies soared from their March 2020 lows into late 2021, while risky corporate bonds also rallied sharply.
The surge in real yields this year has prompted investors to reassess the value of owning companies that may not see big returns for many years. Some private startups like Instacart have agreed to slash their valuations, while shares of loss-making tech companies have fallen more than 30 percent this year, according to Goldman Sachs.
Even America's S&P 500 index, which tracks the country's listed blue-chip companies, is down more than 7% so far in 2022 as rising real yields coupled with uncertainty over the war in Ukraine and high inflation scared investors away. In the corporate bond market, an Ice Data Services index that tracks U.S. junk bond yields is down 6.3% over the same period.
This year's rise in real yields reflects a rise in nominal, i.e. non-inflation-adjusted, borrowing costs triggered by the US Federal Reserve (Fed) raising interest rates and rapidly shedding its $9 billion balance sheet to deal with mounting price pressures to dampen consumers.
Treasury yields have risen more than inflation expectations, a divergence that suggests investors have confidence in the Fed's ability to bring troubling inflation rates down over the coming years. The 10-year break-even rate, a market-based measure of investors' inflation forecasts over the next 10 years, has fluctuated in a range of around 2.75 to 3 percent over the past few weeks, well below March's inflation rate 8.5 percent in 2022.
"There is a reasonable level of confidence in the Fed's ability and willingness to fight inflation," said Ian Lyngen, strategist at BMO Capital Markets. "The issue is not whether the Fed's response to current inflation is appropriate, but market participants' belief that the Fed will adjust policy if necessary."
The rise in real yields also reflects the Fed's ability to tighten financial conditions over time, a shift recognized last week by Lael Brainard, a governor who is set to become the next vice chair.
"Communications about our monetary policy plans over the last four to five months have already tightened the financial environment, much more than could be discerned from interest rates alone," she said at a Wall Street Journal event.
Borrowing costs for businesses have skyrocketed, as have mortgage rates for consumers, which Freddie Mac said last week hit 5 percent for the first time since 2011.
Despite the surge, financial conditions are "still fairly easy," said John Madziyire, Vanguard's portfolio manager. "That could mean the Fed needs to do more, but it's too early to know."
Economists are divided on how far real yields could go given the rapid rise that has already taken place. However, some warn they could rise again as the Fed tries to rein in inflation.
"The $64,000 question is how high real yields will go," Lefkowitz said.