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bonds and inflation

May 2021
Marketing Material

Why real yields really matter

Bond investors use several indicators to guide portfolio construction but it's the real yield that deserves their undivided attention.

Bond investors could be forgiven for feeling somewhat disoriented. Past experience doesn’t count for much when the world is in the grip of a global pandemic. Nor is there a handy playbook detailing what to expect once a huge wave of fiscal and monetary stimulus breaks. Yet within this unforgiving landscape there is one indicator whose relevance for portfolio construction remains undiminished: the real yield.

Real yields, the annualised return a benchmark government bond generates once inflation is taken into account, can provide a reliable read on future economic growth and monetary policy; they also have a uniquely strong bearing on the attractions of riskier fixed income assets and currencies.

Real yields are most closely associated with the yield on 10-year US Treasury Inflation Protected Security (also known TIPS), the world’s most heavily traded and liquid ‘linker’

For several years, yields on US TIPS, whose principal and nominal coupon payments are tied to the US Consumer Prices Index, have been negative. They are currently 0.92 per cent below zero.This unusually low reading testifies to the ultra-loose policies central banks have put in place to reflate the economy, and implies investing in ostensibly safe US government bonds will lose money, in real terms, over the long run.


Fig. 1 - Breaking it all down

Real, nominal and breakeven inflation, %

fig1 breakevens.png

Source: Bloomberg, Pictet Asset Management; data taken from 10-year US Treasuries and 10-year Treasury Inflation-Protected Securities over period 05.06.2020-31.03.2021.

A negative real yield has also changed risk calculations. The realisation that an investment staple such as US Treasuries might lock in a loss has been instrumental in encouraging investors to add riskier fixed income securities to their portfolios.

All of which helps explain why a possible spike in US real yields could feature heavily in the investment narrative in the coming months.

As the global economy makes its recovery from the pandemic, central banks will at some point consider withdrawing some of the USD8 trillion of monetary stimulus they have delivered in the past 12 months.2 The speed of policymakers’ pullback, and the amount of inflation they are prepared to tolerate as they tighten the reins, could upend risk and reward calculations for every fixed income asset, from government securities through to corporate bonds and emerging market debt and currencies.

Tracking the real yield can give investors an invaluable steer on how developments could unfold. To understand its significance, it’s necessary to look at the real yield’s relationship with nominal yields.

The yield gap between conventional and inflation-linked debt is critical. Known as the breakeven rate, it is the level at which investors are indifferent to owning one type of security over the other given all available information on price pressures in the economy. Put another way, the differential represents the market’s best estimate of the future level of inflation. The wider the gap, the higher inflation is expected to be in future and vice versa (see Fig. 1).


The four real yield 'regimes'

It is by breaking down the breakeven into its component parts that investors can get vital clues on the future direction of markets, policy and the economy.

Our historical analysis3 of these dynamics reveals the existence of four distinct real yield phases or ‘regimes’. Each regime, which comes with its own unique set of investment implications, is characterised by a specific combination of movements in both the real yield and breakeven rate.

Under regime one, breakeven inflation is rising and is doing so primarily because of a steady drop in real yields. In this phase, central banks persist with interest rate cuts for an extended period to underpin the economy, tolerating the prospect of higher inflation as they do so. A lower or falling real yield also materially improves the risk-reward characteristics of higher-yielding fixed income assets and currencies; the US dollar depreciates.

In regime two breakeven inflation is rising but this time due to a continuous upward move in both nominal and real yields. In this phase, monetary policy is unlikely to loosen any further as interest rates have probably reached their lowest point while an economic recovery is already well underway. At the same time, returns from riskier assets – emerging market debt or speculative-grade bonds, for example - begin to moderate. US government bonds suffer.


Fig. 2 - Real yield regimes
Fig2 regimes.png

Source: Bloomberg, Pictet Asset Management; monthly asset class returns cover period 31.12.1999-31.03.2021. Dollar return taken from Dollar Spot Index. Developed market bond returns taken from following Bloomberg Barclays indices: US Treasury Index, US Corporate Index, US Corporate High Yield Index, Pan-European Corporate Index, Pan-European High Yield Index. Emerging market asset bond and currency returns taken from: JPMorgan EMBI Total Return Index, JP Morgan CEMBI Broad Diversified Composite Index, MSCI Emerging Markets Currency Index.

The defining feature of regime three is a fall in breakeven inflation that comes courtesy of a rise in real yields. In this phase, central banks typically begin withdrawing monetary stimulus to prevent any future overheating of the economy. The dollar tends to appreciate strongly, primarily against emerging market currencies. Rising real yields also undercut valuations for riskier asset classes, curbing investor appetite for risk and causing a decline in higher-yielding and emerging market bonds. Defensive, higher quality bonds such as government and investment-grade debt, outperform.

In regime four, breakeven inflation falls as both nominal and real yields decline, reflecting a sharp deterioration in economic conditions that will ultimately force central banks to cut interest rates. As the probability of an economic slump and deflation rises, returns from riskier bonds remain muted, the dollar stays within a narrow range and government bonds and other higher grade fixed income hold firm.

The state of play

Viewed through this prism, it is clear that markets spent most of the time since the onset of the pandemic in early 2020 in regime one. During that period, real rates drifted lower, breakeven inflation rose, riskier asset classes (see Fig. 3) and currencies strengthened and the dollar weakened.

This occurred as governments and central banks worldwide delivered monetary and fiscal stimulus on a scale not seen since at least the end of the Second World War. A turning point appears to have been reached in the first few days of 2021, when it became clear that Democrats had secured control of both US Houses of Congress following Joe Biden’s November election victory. It was then that attention began to shift to Biden’s ambitious public spending agenda, which then upended earlier assumptions about economic growth, inflation and government borrowing. This marked a transition into regime two, with breakeven inflation rising on the back of a rise in both nominal and real yields.

Fig. 3 - Real yield regimes in the Covid era
Fig3 regime in action.png

Source: Bloomberg, Pictet Asset Management; data taken from following securities US 10-year Treasury, US 10-year Inflation-Protected Treasury Security, US Dollar Index spot rate over period 31.05-2020-31.03.2021.

Looking ahead, one conclusion to draw is that, as vaccination programmes gather pace and allow for a further re-opening of economies, a transition to regime three in late 2021 appears perfectly plausible. That would see the US Federal Reserve scale back its bond purchase programme and real yields rise. Riskier bonds such as high yield and emerging market debt would suffer.

Still, our research shows that regimes do not advance sequentially – a shift from regime two to three is not necessarily any more likely than a transition from regime two to one. Key at this juncture is the pace at which the Fed judges monetary stimulus can be scaled back. One option that would keep regime two in place is a commitment from the central bank not to reduce the size of its bond holdings any time soon.

But whatever the transition, investors should give the real yield their undivided attention.

It has always been a useful guide. Ignoring it now would be folly.