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Beneath Bond Market's Surface, Tumbling Real Yields Boost Other Assets -- Update

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07/17/2020 | 04:22pm EDT

By Sam Goldfarb

U.S. Treasury yields have fallen close to record lows when adjusted for expected inflation, providing an extra boost to riskier assets in response to both better economic data and the promise of continued monetary stimulus.

In recent months, the yield on 10-year Treasury inflation-protected security has dropped sharply even as the nominal 10-year yield has stayed roughly unchanged -- a combination that suggests investors are both dialing up their inflation expectations and not worrying about any increase in short-term interest rates.

Looking at the issue from one angle: a measure of investors' annual inflation expectations based on the difference between the nominal and inflation-protected Treasury yields -- known as the break-even inflation rate -- has jumped to 1.46% from 1.05% on May 1.

At the same time, the nominal 10-year yield has ticked down to 0.63% from 0.64%. That means the inflation-adjusted 10-year Treasury yield, a proxy for the so-called real yield, has slid from around minus 0.4% to minus 0.8% -- a level not reached since late 2012, when the Fed was still responding to the 2008-09 financial crisis.

Taken together, the increase in inflation expectations and decline in real yields both echo and help explain the strong performance of stocks in recent months. A rising break-even rate is typically associated with an improved economic outlook. Falling real yields, meanwhile, can boost the economy by weakening the U.S. dollar and spurring investors to buy riskier assets because inflation is causing them to lose money on their bonds.

Similar to stocks, the break-even rate was initially lifted in the spring by a run of better-than-expected economic data, as states started to ease back restrictions aimed at controlling the coronavirus pandemic. The expected inflation rate got an added push after June 10, when Fed Chairman Jerome Powell delivered a grim assessment of the economy and said officials weren't "even thinking about thinking about raising rates."

Despite Mr. Powell's gloomy tone, investors were eventually comforted by his assurances that the central bank would maintain, and possibly even expand, its stimulus programs, investors and analysts said.

The resulting decline in real Treasury yields is likely intentional, some of those people said. At a time when the Fed has already pinned short-term interest rates to zero, one of the most important ways it can provide further stimulus is by boosting inflation expectations and thereby driving down the expected real yields on Treasurys.

"When you push real interest rates, 10-year real rates, down to negative 80 basis points," that's a sign that "central bank policy and everything else is firing on all cylinders," said Jim Caron, the head of global macro strategies for Morgan Stanley Investment Management's fixed-income team.

There is a darker view of real Treasury yields at current levels. Sometimes even more than nominal yields, real yields are viewed as an important gauge of the economy, since they strip out inflation and are closely linked with the expected pace of economic growth.

As some Fed officials talk about breaking precedent and not raising interest rates until inflation reaches or exceeds their 2% annual target, one key question for investors is what lies behind that message. Are officials merely doing what they can to stimulate the economy or do they have serious concerns about long-term economic problems becoming even worse due to the pandemic?

Even before the pandemic, some officials such as Fed governor Lael Brainard had fretted about developments -- such as an aging population and slowing productivity growth -- that likely had contributed to consistently low interest rates and muted inflation.

In a speech Tuesday, Ms. Brainard reiterated such concerns but added that the coronavirus could cause "persistent damage to the productive capacity of the economy from the loss of valuable employment relationships," among other challenges. She cited research that found benefits to raising rates only after inflation reaches 2%.

Some Fed officials appear concerned that the fallout from the coronavirus pandemic might further reduce the so-called neutral interest rate that neither spurs nor slows growth, said Priya Misra, head of global rates strategy at TD Securities in New York. Their response could be interpreted as an effort to prevent that "by being extra dovish right now."

Still, some investors doubt that the Fed is doing much more than confronting the current crisis.

"The Fed will maybe claim that it's looking at a long-term impact on the economy's potential growth rate" said Sonal Desai, chief investment officer at Franklin Templeton Fixed Income. "I would debate that and say the Fed is really firefighting."

Ms. Desai, who said her team holds a substantial position in inflation-protected Treasurys, also expressed skepticism that the Fed would take a more cautious approach to raising interest rates than it did after the last recession. In that case, the central bank left rates near zero for seven years before lifting them in late 2015, when its preferred gauge of inflation was still well below 2%.

"While the Fed is saying they'll keep rates low indefinitely, I would say let's see," she said.

Write to Sam Goldfarb at sam.goldfarb@wsj.com


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