Quarterly Outlook
Macro Outlook: The US rate cut cycle has begun
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Chief Investment Strategist
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Falling real yields prove that sovereigns are a ticking bomb about to explode
Althea Spinozzi
Head of Fixed Income Strategy
Summary: 10-year real yields are falling and are pushing investors to higher-yielding junk. We find that US high-yield corporate bonds offer a higher buffer against rising inflation compared to emerging market bonds. US investment-grade corporates which provide an average real yield of around 100bps are barely protecting investors from overshooting inflation. The Federal Reserve's average inflation targeting framework (AIT) might prove a dangerous monetary policy as the economy recovers.
Whenever we talk about US Treasuries, we look at nominal yields. However, what happens when we look at the effect that inflation has on these returns? Investors will not be pleased to learn that once inflation is taken into account, their return is negative. As a matter of facts, since the beginning of the year, the US 10-year real yields have fallen into deeper and deeper negative territory, and they are currently offering -0.87%. This means that whenever you buy 10-year US treasuries at 88bps, inflation is eroding more the total compensation that these securities are offering. Thus you lose money.
It is important to note that when we talk about yields, we are assuming that investors buy-to-hold these securities. However, if capital appreciation is taken into account, the prospect of investing in Treasuries changes massively. As a matter of facts, even with the US CPI YOY Index at around 2.5% at the beginning of this year, and US 10-year yields at 1.5%, if one was buying the US benchmark on the first of January, he would have made around 11% in capital appreciation by now.
A complex mix of economic expectations, central bank policies and market sentiment are Treasuries' prices' key drivers. Their rally this year has been driven by a spike of market volatility dictated by risk-off sentiment provoked by the Covid-19 pandemic. On top of that, accommodative central bank policies have pushed yields to historic low levels. Even though Treasuries' capital appreciation has been compelling this year, it is vital to realize that sovereigns offering such a low yield are the riskiest assets to hold on the wake of an improving economy and rising inflation. Investors buying into sovereigns now risk entering in a mice trap that will force them to hold these securities until maturity or to take large losses. Therefore, the time to park liquidity in Treasuries has come to an end, and only active trading strategies can benefit one's portfolio.
The recent FOMC Meeting Minutes should set off investors' alarm bells. The Federal Reserve is looking to alter the scope of its asset purchases, as it is concerned about the rise of long-term yields. Although this implies that the price of treasuries will continue to be supported, it's worrying to think that a fast economic recovery might ultimately exacerbate inflation. Thus, the upside to hold Treasuries is limited as a steepening of the yield curve is inevitable.
The market knows it, and this is why it is desperately trying to position itself to build a nice buffer against a rise in inflation and interest rates. This explains why higher-yielding securities such as junk and emerging markets have risen sharply in the past few weeks. The graph below shows the average real yield offered by US investment grade and high yield corporate bonds as well as emerging market sovereigns. At the moment, US junk offers the greatest buffer against inflation with average real yields around 130bps higher than EM sovereigns. Bad news doesn't travel alone: investors might be pushed further out of their comfort zone as real yields look on their way to fall again. As the chart below shows, the 10-year real yields have broken their support line, and they might soon be testing their older resistance line, which could turn to be their new descending support line. If that were the case, this means that fixed income securities provide less and less protection against rising inflation besides being overpriced. Within the context of the new average inflation targeting framework (AIT), this can come to a great expense. Indeed the Fed explicitly said that it would look at the average inflation over a period of time before tightening the economy. The risk of overshooting inflation all of a sudden becomes real, and lower-yielding bonds will be the first victim to fall.
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