The real impact of negative real yields

Bulls in a China shop.  Stocks edged higher yesterday as investors piled out of Chinese shares and into US shares in a safety trade.  New home sales experienced a drop in July, vastly missing expectations, leaving investors wondering if the housing boom is over.

N O T E W O R T H Y

No satisfaction.  I often write about the unique relationship bonds have with the economy, specifically inflation.  If you are lucky enough to be in your 20’s or 30’s… or teens, you might be wondering “why does this guy write about inflation so much?”  I understand your confusion, because you have never really experienced the meaningful impact of inflation.  Through the 1990’s, inflation hovered around 3% and fell, on average in the early 2000’s, to just above 2% with lots of volatility.  After a brief spike during The Great Recession, inflation receded further, on average, to below 2%.  The fact of the matter is, that since 1982, inflation has only briefly spiked over 5% meaningfully just 2 times, leading up to the pandemic.  If you are lucky enough to be in your 40’s, you may remember how inflation was a big problem in the early 1980’s and late 1970’s where inflation reached almost 15%, and 5% would have been considered low.  If you are lucky enough to be in your 70’s or 80’s, you may remember a very volatile inflationary era in the 1940’s which saw prices rise by almost 20% in ’47.  One of the primary reasons for the more tame inflationary era of the past 30 years is efficiency in the supply chain.  As demand surges, suppliers can more effectively deliver goods to the market which, as we have learned in recent months, keeps prices normalized.  Another factor for recently tame inflation is a more aggressive Fed, whose mandate number 1 is to fight it.  Now that you know the contours of inflation for the past 80 years (reduced to a single paragraph), you shouldn’t be surprised that a few people are concerned about inflation’s recent spike to 5.4%.  We all know what that means for the prices we pay at the grocery store, gas pump, and clothing store, but inflation has an impact on capital markets as well.

Bonds are in a class of security called Fixed Income.  As the moniker implies, a bond literally pays a fixed coupon until its maturity at which time the principal of the note (par) is returned to the investor.  That investment profile works really well for an individual seeking a fixed income return on their investment – the investor knows, with confidence, what they will receive and when (assuming the issuer doesn’t run amok with their finances).  Likewise, for institutions like insurance companies or pension funds , bonds offer them the ability to match fixed payments to their expected annual cash payout requirements.  All of that seems great until your throw inflation into the mix.  If I am retired and I buy some bonds expecting to receive a $1,000 payment twice a year for the next 10 years, I may use those additional funds to supplement my social security and other retirement income.  I am well aware of what $2,000 in extra income will buy me today… at today’s prices, but what if prices rise significantly?  Using that income before the pandemic, I could have filled my car up with gas around 40 times with gasoline at around $2.55 / gallon. With gasoline’s recent rise in price to $3.15 / gallon, I would only be able to fill my car up 31 times.  If I like to travel by road in my retirement, my plans might have to be changed.  That is why bond investors, smart ones at least, focus on real yield, versus nominal yield.  Real yield accounts for expected inflation, so if a bond pays 5% and inflation is around 2%, your real yield is 3%.  Imagine if bonds yield 1.26% and inflation is 5.4%?  Go on, you can read that sentence a few more times ….  …. That’s right, you would have a negative real yield.  Do these numbers seem familiar?  They should be, because 1.26% is the yield on a 10-year treasury today and the last CPI read was at 5.4%. Faced with those negative yields, treasury bond investors are faced with 2 choices:  1) accept the loss of purchase power due to negative yield, or 2) sell the bonds and buy an investment with higher returns.  Many investors will chose option 2 causing weakness in bond prices, which ultimately pushes yields back up to, hopefully, positive real yield. All good in theory, but in recent months we have been experiencing a rise inflation, which should cause yields to rise, however the opposite is occurring and yields are sinking, pushing real yields further into the red. This scenario has most likely caused many investors to seek alternative investments to treasuries… like riskier bonds or the stock market.  At some point when either yields go higher or inflation falls, bond investors will likely return to the comfort of fixed income.  To get there, they will have to sell their high yield bonds and stocks.  So, even if you are not worried that it now costs you $63 to fill your car up when last summer it would have cost you just $43, you should probably pay attention to inflation rates, bond yields, and the S&P500 dividend yield, which is currently at 1.32% – making it the cleanest dirty shirt for yield seeking investors… for now.

THE MARKETS

Stocks rose yesterday, propped up by inflows from selling in Asia. The S&P500 rose by +0.24%, the Dow Jones Industrial Average climbed by +0.24%, the Nasdaq Composite Index traded up by +0.03%, and the Russell 2000 Index added +0.33%.  Bonds slipped and 10-year treasury yields added +1 basis point to 1.28%.  Cryptos jumped by +16.43% yesterday on speculation that Amazon is diving into the crypto market after it posted a job opening for a Head of Crypto payments.

NXT UP

– Durable Goods Orders (June) are expected to have risen by +2.2% compared to the +2.3% in the prior period.

– FHFA House Price Index (May) is expected to show a rise of +1.6%, slower than June’s +1.8% growth.

– Conference Board Consumer Confidence (July) may have slipped to 123.8 from 127.3.

– This morning, Polaris, Centene, UPS, Trans Union, 3M, , Boston Scientific, Raytheon, Sherwin-Williams, JetBlue, Rockwell Automation, General Electric, Sirius XM, and Archer-Daniels-Midland beat estimates while Stanley Black & Decker, PulteGroup, and Corning missed. After the bell, we will hear from Cheesecake Factory, Apple, Visa, CoStar, Maxim, Alphabet / Google, Teledoc, Enphase Energy, Starbucks, Microsoft, and AMD.