Tuesday, May 28, 2013

The biggest change on the margin: real yields

Since the beginning of April, real yields have soared, in what is now the biggest change on the margin to be found in the stock and bond markets.

The chart above shows the real yield on 5-yr TIPS, which is up 80 bps since early last month. This measure of real yields is now at its highest level since early 2012. At the very least, a big increase in real yields on TIPS (which is the flip side of a big decline in TIPS prices) is consistent with a big decline in the demand for the inflation-hedging properties of TIPS.

Real yields on 10-yr TIPS are up 60 bps from their early-April levels. This is an across-the-board increase in real yields.

As the above chart suggests, higher real yields on TIPS are likely driven by improving expectations of future economic growth. The rise in real yields also correlates to increasing hints from the FOMC that an end to Quantitative Easing may be coming sooner than the market had expected. But if the Fed is likely to move sooner than expected, the underlying reason is most likely an improving economy.

As the above chart shows, gold prices have dropped rather precipitously since early April. Declining gold prices likely reflect reduced concerns about the inflationary potential of monetary policy, and they could also reflect reduced concerns about the possibility of another recession or economic collapse. Gold, in other words, is consistent with the message of nominal and real yields.

The chart above shows the difference between the nominal yield on 5-yr Treasuries and the real yield on 5-yr TIPS, otherwise known as the market's expected annual inflation rate over the next 5 years. Expected inflation has fallen by about 50 bps since early April, and most of that decline can be explained by a rise in real yields, since nominal yields are up only 25 bps or so.

To summarize, there have been big changes in the bond market in recent months that point to 1) improving expectations for real economic growth, and 2) somewhat lower inflation expectations. Both of these, in turn, are consistent with the 7% rise in the S&P 500 since early April. These are all healthy developments. Perhaps more importantly, these changes are NOT consistent with the view that the equity market is being pumped up by easy money. If easy money were the driving force, we would be seeing higher gold prices and lower real yields.


Benjamin said...

It looks like the Fed's sustained, open-ended QE program is getting some moderate traction. It took the Fed five years to come to the realization that tight money is not how you revive a modern global economy, but maybe they are getting it.

But there is a real menace in the proposition that the Fed will cease QE.

In 2005, after five years of QE, the Bank of Japan halted QE. Japan went right back to deflation and perma-gloom.

I know it is unsettling to some, but the fact is that QE may have to become a conventional tool.

High global savings rates seem to result in interest rates sinking to zero. If you look at 30-year trend lines on sovereign debt yields, you will see what I mean. The whole world is headed to ZLB.

Okay, in ZLB, the Fed tool of lowering interest rates does not work. It is like fighting a flood with a fire hose.

It may be that modern central banks engage continuously in QE, sopping up capital and (nice!) monetizing national debts.

The new challenge is not inflation, but growth---and maybe how to figure out how to get Congress not to spend the windfall from ongoing QE.

William McKibbin said...

The Fed is adding just enough liquidity to fend off deflation, which remains the greatest risk to the economy in the short-term -- inflation is not even on the radar -- for example, real working wages are stagnant -- likewise, home values are essentially stagnate except in selected regions -- the prices of goods and services are rising, but that's due to global demand, not inflation of the dollar -- I expect real working wages to remain stagnant or decline for the remainder of the 21st century -- only workers with world-class skills (moviestars, professional athletes, surgeons, and so forth) will see wage increases during the 21st century.

Gloeschi said...

So much wrong with this post.

1. Stock market is uncorrelated with nominal bond market yields.

2. Stock market is well correlated with implied (TIPS-derived) inflation expectations (r-square = 0.75 January 2012 - March 2013, a bit less since then).

3. As you correctly point out, despite the rise in yields implied inflation expectations have fallen. If economy was improving, inflation expectations would rise, not fall.

Again, another example on thinly veiled spin by CBP. Sad.

PS: See what rising nominal yields (and therefore mortgage rates) do to the homebuilders?