Negative Real Yields 1: 5y vs 10y
While the inflationary spotlight has spent the past few months rotating its focus between inflation data, nominal yields, and breakeven rates, relatively little attention has been paid to real yields. Why are real yields important, and what do they have to say about expected inflation?
First, we must define what real yields are. They are calculated by subtracting inflation from nominal yields:
Real Yield = Nominal Yield – Inflation
As such, they represent the return investors receive after accounting for inflation.
Now, looking at the chart above, we can see that both nominal and real yields made their lows at the end of August 2020. However, while nominal yields have recovered the losses they made in Feb and March of last year, the height of Covid induced chaos, real yields have not.
Even as the 10y UST yield has captured headlines and everyone’s attention by pushing higher over the past year, real yields still remain mired in negative territory. Instead of following their nominal cousin on a sustained upward move, 10y real yields remain stuck in an approximately 50 basis point range between -0.5% and -1%.
This anomaly is even more pronounced in the 5 year tenor, with 5 year real yields continuing to move lower even after the nominal equivalent bottomed out in early August 2020. It is worth noting that unlike 10y nominal yields, the 5 year equivalent has not recovered its Feb/March 2020 Covid induced losses.
What does all of this mean?
Let us consider this from a less abstract perspective. For each tenor (5 year, 10 year, etc) real yields are represented by yields on TIPS (Treasury Inflation Protected Securities), and nominal yields by yields on US Treasuries. Both yields represent demand for the two different financial instruments.
As such, negative real yields means that demand for TIPS is very high. Considering that TIPS’s distinguishing feature is that they protect an investor’s principal against inflation, high demand for them implies high demand for protection against future inflation.
The obvious conclusion here is that the bond market is pricing much higher future inflation, in line with the mainstreams call for inflation spiraling out of control in the near future if the Fed does not change its stance. This view is supported by 5 year real yields being more negative than 10 year ones.
But, are matters really that simple?
If they were, why is it that 5 year nominal yields have not recovered as strongly as the 10 year? Surely if inflation is expected to be higher and “out of control” over the short and medium term, then 5 year nominal yields should have at least recovered from their 2020 losses. But they haven’t, which means that there has to be another way of thinking about 2021’s negative real yields.
To be continued…
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