Ahead of the release of the April personal consumption expenditures price index on Friday, real yields across the American maturity spectrum have been increasing as investors price in rising inflation and an unsustainable fiscal path.
In addition, there is the prospect of private investment being crowded out as the government issues ever more debt and as tech firms tap the private sector to finance the buildout of data centers.
The result is a rising cost of capital.
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While we expect the top-line PCE, which the Federal Reserve uses to set monetary policy, to rise by 0.5% on the month and by 3.8% annually, investors appear to be looking past April’s data and have been pushing real yields higher to reflect the risk of structural changes in the global and American economies.
That repricing of risk reflects not only the supply shock set off by the war in the Middle East, but also an insufficient aggregate supply of advanced materials that tech firms so desperately need for the AI buildout.
So why do investors focus on real yields?
Real yields are a benchmark used to estimate the actual cost of capital. As real yields decline, the present value of future cash flows increases. When real yields rise, the value of future cash flows declines.
The pricing of real yields in turn sets corporate rates, affects housing affordability (via real mortgage rates) and influences the ability of the fiscal authority to sustainably increase its deficits, not to mention affecting Fed monetary policy.
On a global basis, real yields drive currency values and capital flows. Rising real yields tend to cause financial conditions to tighten and the dollar to appreciate, and to push capital out of riskier assets into the safe haven of dollar-denominated assets.
These dynamics happened in 1994, when a currency, banking and financial crisis roiled emerging markets.
One of the more interesting twists under current conditions is that many global investors are wary of holding too many dollar-denominated assets and are repricing such assets.
Should real yields move in a disorderly manner, financial stability concerns increase, which is what happened during the UK gilt crisis in 2022, proving it is not just emerging markets at risk.
So where have real yields been moving since the recent supply shock?
Since March 1, at the beginning of the Iran war, real yields have increased by 38 basis points on the U.S. 10-year Treasury, to 2.07%, and by 20 basis points on the 30-year, to 2.74%.
More pertinently, real yields on two-year Treasury Inflation-Protected Securities increased by 82 basis points over that time, which shows that investors have been pricing in higher inflation in the near term.
This is why investors are pricing in a greater probability of rate hikes than rate cuts by the Fed over the next year.
While that rise is nowhere near the 361-basis point move higher in 10-year TIPS between December 2021 and October 2023, which hurt bond prices and equity valuations, the recent move higher in global bond yields among the major economies requires monitoring at both the front end and long end of the curve.
