- With the U.S. Federal Reserve hoovering up Treasuries like every market day was Black Friday, real yields for the risk-free asset turned negative.
- But now, real yields are approaching a place that had been considered hitherto unreachable – zero.
A low yield environment had been used as justification for the valuing practically ever manner of risk asset in the period since the 2008 Financial Crisis.
But when real yield (yield from a U.S. Treasury less inflation) turned negative because of the pandemic was when risk assets really got supercharged.
With the U.S. Federal Reserve hoovering up Treasuries like every market day was Black Friday, real yields for the risk-free asset turned negative.
But now, real yields are approaching a place that had been considered hitherto unreachable – zero.
To be sure, all U.S. Treasury yields have climbed this year as the Fed took the first of what is expected to be a series of aggressive rate hikes aimed at cracking down on inflation, but that climb has now spilled over in the past two weeks to Treasury Inflation Protected Securities or TIPS.
TIPS yields are considered “real” because they represent the rates that investors will accept if coupled with extra payments to offset inflation and for borrowers, represent something akin to the “true cost” of money.
For 10-year loans, the “true cost” of money has been negative since early 2019, in other words you’d be silly not to take out a loan and make another bet on some other asset, anything would do.
But 10-year real yields on TIPS surged to -0.15% from -0.49% over the past week and are closing in on that point where it might actually cost money to borrow money and force a re-examination of asset valuations, from equities to cryptocurrencies.
A TIPS index, which tracks the prices of TIPS, has lost 3.3% in the first three months of this year for a total return of -4.7% in the year to March 23, while comparable non-inflation protected Treasuries have been hammered, losing -7.8% over the same period.
U.S. Treasuries have outperformed in the past two weeks though, losing just 2.4%.
But investors can expect that both Treasuries and TIPS yields will become even more volatile in the coming weeks.
As Russia gears up for a final showdown in Ukraine’s eastern regions, a rout of Russian forces could either escalate the conflict towards nuclear Armageddon, or force a détente akin to when the Finns drove the Russians out of Finland.
When the Fed expanded its balance sheet in response to the pandemic, TIPS accounted for a larger share of its outstanding securities and if the Fed no longer buys, yields could become positive again.
Although stocks nursed a week of losses in the first week of April, it’s entirely possible that they will rebound, given their relative resilience and the time that the markets have now had to digest the prospect of the pace at which the Fed is running off its balance sheet (not replacing maturing Treasuries and mortgage-backed securities with fresh ones).
Investors are wading deeper and deeper into uncharted territories, because the Fed hasn’t tightened solely because of inflation since the 1980s and that uncertainty is being reflected not just in TIPS and yields, but in market volatility as well.
