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Negative real rates’ house of cards might soon collapse

Althea Spinozzi
Head of Fixed Income Strategy

Summary:  Inflation's rising and the yield curve's steepening. How can bond investors navigate the changing financial landscape?

Real rates are going to be a central theme of the investment narrative in the upcoming months. Since the Covid-19 pandemic, financial markets have grown heavily dependent on the loose financing conditions that negative real rates provide. In order to avoid a loss in real terms, investors have been encouraged to take on more risk, causing junk bond spreads to tighten to levels seen before the 2008 global financial crisis. However, as central banks begin to consider less accommodative monetary policies, it's inevitable that real rates will rise and risky assets will suffer.  

The relationship between real rates and breakevens: what it means for bond investors

Real rates are compounded by nominal rates minus breakeven rates. Since the beginning of the Covid-19 pandemic, extremely accommodative monetary policies caused interest rates to fall while inflation expectations continued to be stimulated. As a consequence, real rates fell into deeply negative territory, hitting record low levels. However, as central banks look to withdraw stimulus, it’s safe to expect higher nominal yields and lower inflation expectations. Such an acceleration in the surge of real rates can pose a threat to risky assets. 


Source: Bloomberg and Saxo Group

The relationship between real yields and breakevens provides a compass for bond investors and can be summarised in four phases:

  1. Real yields fall, breakevens fall. This happens when economic conditions are deteriorating, as happened during the Covid-19 pandemic. In such a case, central banks cut interest rates and provide stimulus. This scenario brings gains to investment-grade corporate bonds and safe havens. In contrast, riskier bonds initially fall, then stabilise slowly afterwards.
  2. Real yields rise, breakevens rise. Rates have bottomed and the economic recovery is underway, leading central banks to steer away from their accommodative monetary policies. In this phase, government, junk and emerging market bonds' returns begin to moderate, and US Treasuries suffer.
  3. Real yields fall, breakevens rise. In this scenario, the economic backdrop is recovering. However, central banks are willing to overlook higher inflation expectations because they believe that the economy needs stimulus. In this case, junk bonds remain well bid, while safe havens are rangebound.
  4. Real yields rise, breakevens fall. In this case, central banks begin to adopt more aggressive monetary policies to prevent the economy from overheating. Junk and emerging market bonds suffer while defensive, higher-grade bonds outperform.

Phase one describes quite accurately what we have seen during the Covid-19 pandemic. In contrast, phases two and three can be pinpointed to specific periods of this year. For example, phase two describes the reflation trade we saw in markets in February. 

Currently, the bond market depends entirely on how central banks look at inflation and how they decide to deal with it. So far, the Federal Reserve has decided that inflation is transitory, providing ample support for bonds broadly. However, we cannot ignore the fact that the Fed's reluctance to taper adds to the inflationary upside risk. Indeed, even if the central bank begins to taper purchases under its bond purchasing program, inflation will inevitably be stimulated until purchases go to zero.

Therefore, the question that should press investors is what is the amount of inflation that central banks are willing to tolerate, and at what pace may they pull support. We believe that the later support is pulled, the more aggressive central banks need to be, provoking an unexpected rise in real yields that will increase market volatility and put weaker corporates at risk.


Source: Bloomberg and Saxo Group

Corporate bond spreads depend entirely on central banks’ monetary policies

Corporate bond spreads, and risky assets more broadly, react to the volatility of rates rather than the actual level of yields. Yet, despite this year, while government bond yields in the United States and the old continent rose quite sharply, corporate bonds barely budged. In the United States, 10-year yields rose 45bps in February, yet corporate bond spreads widened only by 10bps within the same period. The same can be said about corporate bonds in the UK, which saw 10-year Gilts yields quadruple in the same month. At the same time high-grade corporate spreads even tightened seven basis points, hitting the lowest level since January 2018.

What has played in favour of corporate spreads this year is the economic recovery, which saw earnings improving amid the reopening of the economy. However, things can change fast if inflationary pressures become persistent and central banks need to taper more aggressively than the market forecasts. Currently the market isn’t pricing aggressive monetary policies at all, providing ample support to all corporates, including those with weak balance sheets (also known as zombies). But credit spreads at record tight levels represent a threat because they are highly dependent on accommodative monetary policies. As soon as central banks become aggressive, we can expect spreads to widen substantially and defaults to rise.


Source: Bloomberg and Saxo Group

High inflation and yield curve steepening: bond sectors that can benefit from it

As we explained, monetary policy is critical to the performance of corporate bonds. Indeed, if central banks continue to tolerate inflationary pressure, it’s safe to assume that corporate spreads will continue to be supported and that corporates that benefit most from the opening of the economy will gain.

If we expect inflation to remain sustained and the yield curve to steepen amid stable monetary policies, the banking and financial sector could provide exciting opportunities. Banks borrow short term to lend money long term. Thus, a steeper yield curve would improve their net interest rate margins. Additionally, banks will continue to benefit from the reflationary environment as the economy reopens and demand for loans and investments increases. Financial brokers and insurers will also benefit as a healthy economy increases investment activity.

Cyclical industries can also perform well in such an environment, and it's important to pick those that can easily pass the rise in costs to their customers. So far, basic materials and commodities producers have been able to do so amid soaring commodity prices. In contrast, non-cyclical industries such as food and beverages and the retail sector have been less able to pass costs to their customers.

Things are different if central banks have to adopt more aggressive monetary policies to curb inflation. The key within this scenario is to stay defensive, and keep the duration to a minimum and quality high. Amid a fast tightening of financial conditions, defensive industries such as consumer staples and utilities would be supported. However, duration picking remains vital. For example, utility bonds by nature have very long maturities and are more vulnerable to a steepening of a yield curve. 


Source: Bloomberg and Saxo Group

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