Negative Real Yields Unlikely To Last

  • Negative real yields have unmoored asset prices from fundamentals.
  • Mounting, though transitory, inflation pressures are likely to start pushing real yields higher.
  • Higher real yields should feed into lower risk asset valuations.

In the United States, the economy has recouped nearly all the ground lost during the pandemic, and corporate earnings aren’t far behind. As I wrote in March’s “A Year Like Few Others,” risk assets have discounted this V-shape recovery, but as economic and earnings data evolves from forecast into fact, markets are looking ahead to see what’s next. And I believe what’s next will be a day of reckoning as investors grapple with higher yields. Here’s why.

Every investment opportunity is ultimately weighed against competing possibilities for use of funds. The decision to allocate capital happens only if the investment will clear its hurdle rate. While the height of every investment hurdle is determined by its idiosyncratic risk, real, inflation-adjusted interest rates are the first input into that calculus.

Anchors aweigh

During the 2020 recession, central bankers were determined not to allow lockdowns to morph into a credit crisis. In order to buoy animal spirits, policymakers removed the first rung in the ladder of every hurdle equation by driving real US Treasury yields deeply into negative territory, as illustrated in Exhibit 1 below.

In the years leading up to the pandemic, the real yield on the 10-year US Treasury Note lived in a meager range below 1%, but at least it was positive and provided investors with some sort of measuring stick.

However, financial theory holds that asset prices are lognormal, meaning they can’t go negative. Since capitalism requires a hurdle rate, business schools or CFA prep courses don’t teach students how to value a company or a project with negative nominal or real interest rates. Without an anchor, it’s apparent why risk assets have risen as they have. Exhibit 2 overlays the advances made by the S&P 500 and MSCI World indices from their pandemic lows against the path of U.S. 10-year Treasury real yields into negative territory.

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Disclaimer: The views expressed are those of the author(s) and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a ...

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Andrew Armstrong 1 week ago Member's comment

Enjoyed this, thanks.