Real Yields Are the Market’s Big Lie


While you are undergoing radiotherapy for prostate cancer, you need to drink plenty of water to keep your bladder “comfortably full”. Sitting in the hospital waiting for my chipped teeth to be treated, I felt, not for the first time, that the meaning of the word “comfortably” was stretched beyond the breaking point when an old man turned to me and asked if I was Richard Cookson. I was very excited and impressed that my old philosophy teacher recognized me. So, it was almost 40 years since we saw each other.

I was also a little embarrassed that he recognized me first. He is one of the nicest people I have ever met. In lectures he would sit and listen intently to carefully constructed arguments (or so I hoped) with a kind of cheeky charity before destroying them with the loneliest question. To his surprise, I said philosophy was the most useful subject I had ever studied because it taught me to question and think.

Much of what people think and write about in the financial markets is not taken into account. A topic that has engaged central banks and markets of late is forward-looking measures of real output. The more I’ve written about them myself, the more I believe they mean as much as the word “comfort”.

Real yields reflect the difference between the inflation rate and interest rates. Positive real yields occur when interest rates are higher than inflation and negative real yields occur when the opposite occurs. Real products are reasonably easy to measure after the fact (what economists call ex post). You look at interest rates and inflation over a given period and see if the former has compensated you for the latter. The real current rate measure is a variation on this: You compare the residual inflation rate to current interest rates. So, despite central bank rate increases, the latest from the European Central Bank last week, current real rates are still massively negative everywhere because inflation is much higher than interest rates.

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So far, pretty straightforward stuff. Actual future (ex ante) yields are much more interesting but much more problematic. The real yields everyone looks at are the real yields on inflation-linked government bonds, although many of them are smaller in terms of implied and illiquid amounts. The most liquid and studied are those issued by the United Kingdom and the United States.

These are real in the sense that such instruments provide a coupon plus accumulated inflation over the life of the bond. This is done slightly differently in the UK and the US, but since investors will eventually be compensated for inflation over the life of the bond, their interest in how much they are willing to pay for those flows, the actual yield. is Many people think that how it rises and falls gives some idea about the tightening or otherwise of monetary policy. Inflation-linked bonds also provide a sense of expected inflation, simply by reducing the real yield from the yield on a traditional bond of the same maturity. Part of the reason governments issue inflation-linked bonds is so policymakers can track both measures.

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In recent months, the rapid rise in real yields combined with the drop in expected inflation has led many – including central bankers – to wonder if central banks are in danger of hitting the monetary brakes too hard. Strategists and economists across the financial establishment have weighed in on this confusion and warned about the resulting risks. My problem is that they are so obviously wrong. At the beginning of 2020, the market’s best estimate was that US inflation would be 0.22% over the next five years. Inflation has been very high and real rates have therefore become very low. More problematic is that those results do not mean what people think they mean and in recent years they have become more and more misleading.

Get real rates. Many have argued that the big fall in inflation-linked bond prices in both the UK and the US over the past year is because real rates have risen. This is very true but very misleading. It is more accurate to say that real rates have increased because of large sales of inflation-linked bonds by investors. Real output growth had absolutely nothing to do with monetary policy being too tight. Honestly, I’m not really sure what that tells you, other than that they were overpriced and the largest pool of potential buyers were the ones who needed to sell.

For its part, as I said, inflation expectations only measure the difference in yield between conventional and inflation-linked bonds. The number is more accurately called the inflation rate. It is the rate at which, based on current information, investors are indifferent to buying inflation-linked bonds or government bonds of the same maturity. But all of those real-by-definition yields mean even less when yields on traditional bonds are so much less manipulated by central banks, in quantitative easing or by accumulating foreign exchange reserves. I estimate that central banks around the world hold something like $35 trillion in government debt.

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If yields on conventional bonds can’t rise as much as they should because there aren’t enough around, default rates will fall, versus a massive selloff in inflation-linked bonds. It tells you a lot more about the decline in traditional bonds around the world than the likely path of inflation, central bank confidence or anything else. None of this means that inflation will go down, just that, as my teacher said, movements in real rates or failing inflation don’t tell you anything interesting anyway. More from Bloomberg Opinion:

• The Fed Should Think in Terms of the Trilemma: Mohamed El-Erian

• Whatever You Do, Don’t Name The Pivot: Daniel Moss

• Biden Hurts, Doesn’t Help, Economy: Allison Schrager

This column does not necessarily reflect the editorial opinion of Bloomberg LP or its owners.

Richard Cookson was head of research and fund manager at Rubicon Fund Management. Previously, he was chief investment officer at Citi Private Bank and head of asset allocation research at HSBC.

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