Real Yields Pose a Threat to the Stock Market

The TINA move

Here we are talking about bonds, again, and how the bond market will probably cause a pullback in equities. The good old days of the 60/40 portfolio model are long gone.

These are dangerous times, especially if you look at the macroeconomic factors. Raging inflation and a slowdown in growth, unprecedented stimulus and tons of liquidity in the market. The list can go on and on.

Investors have a lot of cash on their hands and no place to put it at work. This is why the Fed Overnight Repo is gathering so much cash. They are trying to mop all the liquidity they have brought in the market.

The bull run in equities was not only caused by loose monetary policies, but also because There Was No Alternative(TINA). You weren’t going to put money into the bond market where inflation would eat all your profits.

Let’s take an example.

The bond market is projecting that 10-year Treasury yields will hold below the inflation rate for the next decade, meaning any investment income will be more than wiped out by the rising cost of living.

At the moment of writing, the 10 year bonds offer a yield of 1.42%. Now, if you think this is a good investment, especially for risk-off investors, you are wrong.

This is a terrible investment. We also must analyze where inflation is going to be in the next 10 year in order to make a decision.

You can’t boast about turning a profit from this risk off investment at the Christmas table if, after 10 years, the buying power of your profit is less.

Now, when we account for inflation, the yield is called real. And it is negative…

With high inflation expectations, this can’t be called a surprise.

Right now, the real yield for the 10 year bonds is -1%.

Not such a great investment after all…

To better understand that we live in some abnormal times, let’s look in the past.

In 1982, the last time year-on-year inflation surged as much as it did in November, the 10-year yield climbed as high as nearly 15%. It’s below 1.5% now.

I guess the Federal Reserve wasn’t buying bonds as crazy as nowadays.

Therefore, left with no other choice(TINA thesis), investors put money into stocks and pushed the market to all time highs and turned a nice profit.

Now, we must sniff the next possible catalyst that could cause the yields to push and make bonds attractive again. This may come in the form of a faster taper announcement.

The Fundamental Argument

As the Federal Reserve tapers its monthly bond buying, the price will fall, resulting in nominal yields pushing higher and lower inflation expectations.

If you do the math correctly, the result should be higher real yields. With higher real yields, investors who are more risk-averse or want to add bonds to their portfolio may get some money out of the stock market and into the bond market.

The result: a selloff in equities.

The threat seems more real as Jerome Powell starts to realise that inflation is not transitory. Also, he seems to have become more of a hawk.

With a hawkish Federal Reserve, the taper may accelerate and the whole thing should happen sooner and faster, although nothing is sure yet.

Goldman Sachs Group Inc. strategists led by Praveen Korapaty predict that 10-year real yields will only rise to minus 0.85% next year, leaving them in a negative territory for a record third year in a row.

A better conclusion could be drawn after tomorrow’s FOMC meeting.

The technical aspect

We neglected to post about technical analysis in our posts, but that doesn’t mean we neglect it when we do our analysis.

If we look at the US 10 year inflation adjusted yield index, we can easily notice a double bottom, as Bloomberg mentioned in one of their articles. But there is more than what Bloomberg reported.

We got several touches of the descending trend line. This suggests that bearish momentum fades away and we must embrace for an upside breakout.

Conclusion

We layed out just two arguments why the real yield is about to go up. Once yields head up, bond prices will fall from their highs, making them more attractive to investors and offering a decent return adjusted for inflation.

Stocks may be overvalued, but bond prices are far worse and therefore they pose a far greater risk. Premium depreciation and a negative real yield is not exactly the best investment decision.

Bonds will become attractive again, maybe not next year, but they will and, as a result, stocks may have to suffer as the TINA(There Is No Alternative) thesis will get canceled.