Today see’s the release of an excellent primer on the potential for rising real bond yields. The Focus report Tricio is called “Brace for Higher Real Yields” and its by their Chief Economist John Calverley.

The idea that bond yields might start to rise is not remotely new but the report nicely maps out the changing landscape and likely drivers of increasing real yields. I have to say that I am sympathetic to this argument but I’m also wary of those who think we’ve somehow shaken off a long deflationary interlude. Sure inflation rates are increasing but this might – might – be transitory and globalisation might actually intensify as producers look for ways to reduce costs.

Anyway, that’s the broader debate but the chart below nicely sums up the current predicament. The average real yield on UK linkers is now hovering around 3% which is I think an unsustainable position long term i.e pension funds are actively destroying their unit holders wealth.

Calverley reminds the Tricio readers that real yields are ultimately “determined by the balance of desired savings and investment in the economy. For the last 10-20 years desired saving has been higher than desired investment, forcing interest rates lower to equilibrate them”.

The drivers of these negative yields are obvious for all to see.

  • Savings have been boosted by baby boomers, rising inequality and a China surplus.
  • China is a key factor with huge internal investment and a persistent current account deficit – This surplus in effect feeds into the world economy as China buys up foreign assets. Over the next 10 years both savings and investment are likely to decline in China as a percent of GDP.
  • Investment has also been low – powered by lower population growth, lower government investment, cand a declining cost of equipment (partly through technology)

Tricio’s chief economist argues that some of these forces are now unwinding. The baby boomers are now retiring, drawing down on their savings, the China surplus is falling and the OPEC surpluses have already gone. In terms of investment, population growth is slowing which prompts concern of Japanification which would still mean “ a rise in real interest rates, to around zero, or even above if deflation was severe”.

“Our view is that, after trending down for the last four decades and reaching low negative levels currently, a rise in real rates should be expected in coming years. The balance of desired savings and investment should shift. Note that this is independent of what happens to inflation. If inflation proves to be persistently high then nominal rates could rise even more as central banks try to bear down on it.”

For Calverley the investment implications are clear. Index linked bonds will not – as I have argued in Citywire – represent a safe haven. They’ll be growing fiscal pain for indebted government’s, possibly resulting in austerity, and there will also be obvious pressure on valuations for stock and property markets – maybe resulting in a rotation from growth into value.

As I said, I’m not convinced that we have escaped the deflationary trap, so I’m not entirely convinced that all this will come to pass but the odds of real yields turning positive must be above the possible, nudging into the probable.

Sticking with the whole macro debate around real yields and inflation, there’s an interesting piece out today from data specialists at Qontigo. They’ve just published a whitepaper on Inflation and Its Impact on the Stock-Bond Correlation where they examine the historical interaction of equity and bond-market returns over the last 60 years to identify the main triggers of shifts in their relative directions—especially situations that might prompt the two asset classes to persistently move together. They have identified three possible scenarios.

  • Scenario 1: Inflation surges and remains well above 2.5% for a prolonged period
  • Scenario 2: The Federal Reserve tightens monetary policy beyond what is justified by economic growth
  • Scenario 3: Long US Treasury yields rising significantly to compete with equity earnings yields

The charts below sum up the likely scenarios emerging from the most probable outcome – scenario 1. They both show the connection between the average level of inflation and the relative movements of stock and bond prices.

In scenario 1 – inflation diverging for a prolonged period of time above 2% – the two asset classes appear to move in tandem.

“The chart on the right suggests a corridor from 1.6% to 2.4%. This seems to be supported by the fact that over the past 18 years, the 10-year US Treasury breakeven rate has been between 1.5% and 2.5% for 80% of the time (90% between 1.4% and 2.6%), and that the stock-bond interaction tended to turn positive when inflation expectations moved outside of these boundaries.

 They key shift to watch out for in terms of stock bond correlation are key shifts in how consumer prices develop over the next year or two.

“Thus far, market-implied inflation expectations appear to be buying into the Fed’s narrative that the current spike is only transitionary. As long as it stays that way, multi-asset class investors should be able to continue relying on sovereign debt for risk diversification and downside protection.”

One stockmarket follows its own logic in these various scenarios – Japan. Its government bonds are actually producing a positive real yield and its stockmarket is relatively good value compared to other developed world markets. Local equities have now caught the eye of  Charles Ekins at multi asset specialist Ekins Guinness who has started aggressively into Japanese equities.

He argues that there is a “ strong strategic case for Japan which our model has picked up on. Relative Value Yield for Japanese equities versus USA is currently +2.7%. This is not quite as high as it was in 2011-2013, after which Japan outperformed (Japan stayed “cheap” for a while following the terrible 2011 earthquake tsunami). Nevertheless, relative Value Yield of +2.7% now is very attractive. The chart below puts this into an historical perspective – and it highlights the negative relative Value Yield for Japan in the 1980’s bubble.”

Last but by no means least, an interesting financial footnote on the power of indices.

For many years investors have been obsessed with the idea of the index effect i.e when a stock moves into a major, tracked index, the share price starts to appreciate because of heavy passive buying. Will this index effect become more pronounced as passive funds become more powerful or will the impact be slowly arbitraged away? Analysts from S&P Dow Jones have dug around and come up with a surprising conclusion. It’s not as powerful as it sued to be.

This conclusion comes in a research paper, What Happened to the Index Effect? A Look at Three Decades of S&P 500 Adds and Drops,”. S&P Dow Jones analyzes the additions and deletions to the S&P 500 from 1995 through June 2021 to determine the full extent of the supposed index effect. The analysis confirms that the S&P 500 index effect seems to be in a structural decline.