Real Yields Are the Market’s Big Lie


When you undergo radiation therapy for prostate cancer, you need to drink plenty of water so that your bladder is “comfortably full.” Sitting in the hospital waiting to be treated with gnashing teeth, I was thinking, not for the first time, that the meaning of the word “comfortable” extended beyond the breaking point when an elderly man turned to me and asked if it was Richard Cookson. I was deeply moved and liked that my old philosophy teacher had gotten to know me. It’s been almost 40 years since we last saw each other.

I also felt ashamed that he got to know me first. He is one of the most impressive people I have ever met. In the tutorials, he sat listening intently to carefully designed arguments (or so I hoped) with some kind of sparkling favour, before tearing them down with the simplest question. To his surprise, I said that philosophy was the most useful subject I had studied because it taught me to question and think.

A lot of the things people think about and write about in the financial markets don’t stand up to much scrutiny. A topic that central bankers and markets have been practicing lately is forward-looking metrics for real returns. As much as I have written about them myself, I am increasingly of the opinion that they are as important as that word “comfortably”.

Real returns represent the difference between the inflation rate and interest rates. Positive real returns occur when interest rates are higher than inflation and negative real returns when the opposite occurs. Real returns are easy to measure after the fact (what economists call retrospective). You look at interest rates and inflation over a given period to see if the former has compensated you for the latter. Current real rate metrics are a variation on this: you compare the delayed rate of inflation with current interest rates. Hence, despite the central bank’s interest rate increases, the most recent by the European Central Bank last week, current real rates are still significantly negative everywhere because inflation is much higher than interest rates.

So far, things are straightforward. Future (past) real returns are more interesting but more problematic. The real future yields that everyone is looking at are the real yields on inflation-linked government bonds, although many are smaller in terms of outstanding and illiquid amounts. The most liquid and studied are those issued by the United Kingdom and the United States.

These are real in the sense that these instruments provide a coupon as well as accumulated inflation over the life of the bond. This is done slightly differently in the UK and US, but since investors will eventually be compensated for inflation over the life of the bonds, their enthusiasm for how much they are willing to pay for these flows is the real return. Many people think that how much it goes up and down gives an idea of ​​the tightness or lack of monetary policy. Inflation-correlated bonds also provide a sense of expected inflation, simply by subtracting the real yield from the yield on traditional bonds with the same maturity. Part of the reason why governments issue inflation-linked bonds is to enable policymakers to track both metrics.

In recent months, the rapid rise in real yields coupled with expected lower inflation has led many – including central bankers – to question whether central banks are in danger of pressing too hard on the monetary brakes. Strategists and economists across the financial establishment have looked at the mix and warned of the risks involved. My problem is partly that they were clearly wrong. In early 2020, the market’s best guess was that US inflation would be 0.22% over the next five years. Inflation was much higher, so the real rates are much lower. Even more problematic is that these results do not mean what people think they mean, and in recent years they have become more misleading than ever.

Take the real prices. Many have argued that the massive fall in inflation-linked bond prices in both the UK and the US at that time over the past year was due to higher real interest rates. This is trivially true but very misleading. It is much more accurate to say that real prices rose due to the massive selling by investors of inflation-linked bonds. The rise in real yields had absolutely nothing to do with monetary policy becoming tighter. To be honest, I’m not really sure what it’s telling you, aside from the fact that it got pretty expensive and the largest group of potential buyers were also the ones that needed to sell.

For their part, as I said, inflation expectations only measure the difference in yield between conventional and inflation-linked bonds. The figure is more accurately called the break-even inflation rate. It is the rate at which investors, in light of current information, are indifferent to buying inflation-linked bonds or government bonds with the same maturity. But all of these real yields by definition mean less when yields on conventional bonds are manipulated much less by central banks, in quantitative easing or through the accumulation of foreign exchange reserves. I think central banks globally have roughly $35 trillion in government debt.

If conventional bond yields cannot rise as much as they should because there is not enough around, it will follow that, in the face of massive selling of inflation-linked bonds, break-even rates will fall. This tells you a lot more about the scarcity of traditional bonds around the world than it does about the likely path of inflation, the credibility of the central bank, or much else. None of this means that inflation won’t go down, just as my tutor said, movements in real prices or break-even inflation don’t tell you anything interesting either way. More Bloomberg’s opinion:

• The Federal Reserve should think from a tripartite perspective: Mohamed El-Erian

• Whatever You Do, Don’t Remember The Hub: Daniel Moss

• Biden hurt the economy, not helped it: Alison Schrager

This column does not necessarily reflect the opinion of the editorial staff or Bloomberg LP and its owners.

Richard Cookson was Head of Research and Fund Manager at Rubicon Fund Management. Previously, he was Chief Investment Officer at Citi Private Bank and Head of Asset Allocation Research at HSBC.

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