Senior Fixed Income Strategist, Saxo Bank Group
Summary: 10-year real yields are falling and are pushing investors to higher-yielding junk. We find that US high-yield corporate bonds offer a higher buffer against rising inflation compared to emerging market bonds. US investment-grade corporates which provide an average real yield of around 100bps are barely protecting investors from overshooting inflation. The Federal Reserve's average inflation targeting framework (AIT) might prove a dangerous monetary policy as the economy recovers.
Whenever we talk about US Treasuries, we look at nominal yields. However, what happens when we look at the effect that inflation has on these returns? Investors will not be pleased to learn that once inflation is taken into account, their return is negative. As a matter of facts, since the beginning of the year, the US 10-year real yields have fallen into deeper and deeper negative territory, and they are currently offering -0.87%. This means that whenever you buy 10-year US treasuries at 88bps, inflation is eroding more the total compensation that these securities are offering. Thus you lose money.
It is important to note that when we talk about yields, we are assuming that investors buy-to-hold these securities. However, if capital appreciation is taken into account, the prospect of investing in Treasuries changes massively. As a matter of facts, even with the US CPI YOY Index at around 2.5% at the beginning of this year, and US 10-year yields at 1.5%, if one was buying the US benchmark on the first of January, he would have made around 11% in capital appreciation by now.
A complex mix of economic expectations, central bank policies and market sentiment are Treasuries' prices' key drivers. Their rally this year has been driven by a spike of market volatility dictated by risk-off sentiment provoked by the Covid-19 pandemic. On top of that, accommodative central bank policies have pushed yields to historic low levels. Even though Treasuries' capital appreciation has been compelling this year, it is vital to realize that sovereigns offering such a low yield are the riskiest assets to hold on the wake of an improving economy and rising inflation. Investors buying into sovereigns now risk entering in a mice trap that will force them to hold these securities until maturity or to take large losses. Therefore, the time to park liquidity in Treasuries has come to an end, and only active trading strategies can benefit one's portfolio.
The recent FOMC Meeting Minutes should set off investors' alarm bells. The Federal Reserve is looking to alter the scope of its asset purchases, as it is concerned about the rise of long-term yields. Although this implies that the price of treasuries will continue to be supported, it's worrying to think that a fast economic recovery might ultimately exacerbate inflation. Thus, the upside to hold Treasuries is limited as a steepening of the yield curve is inevitable.
The market knows it, and this is why it is desperately trying to position itself to build a nice buffer against a rise in inflation and interest rates. This explains why higher-yielding securities such as junk and emerging markets have risen sharply in the past few weeks. The graph below shows the average real yield offered by US investment grade and high yield corporate bonds as well as emerging market sovereigns. At the moment, US junk offers the greatest buffer against inflation with average real yields around 130bps higher than EM sovereigns.
Bad news doesn't travel alone: investors might be pushed further out of their comfort zone as real yields look on their way to fall again. As the chart below shows, the 10-year real yields have broken their support line, and they might soon be testing their older resistance line, which could turn to be their new descending support line. If that were the case, this means that fixed income securities provide less and less protection against rising inflation besides being overpriced. Within the context of the new average inflation targeting framework (AIT), this can come to a great expense. Indeed the Fed explicitly said that it would look at the average inflation over a period of time before tightening the economy. The risk of overshooting inflation all of a sudden becomes real, and lower-yielding bonds will be the first victim to fall.
The market is trying to get back to the pre-Covid and pre-war times, but that model is broken. A new dawn is here and the financial world needs to adapt.
Steen Jakobsen,
Chief Investment Officer
A political switch in China towards less tough control of its people and companies may kick things back into gear.
Redmond Wong,
Market Strategist
While the economic situation in Europe may not be as bad as feared, there's still a plethora of things to fix.
Chris Dembik,
Head of Macroeconomic Research
As the world turns increasingly bipolar, equity markets face harsh times as they transition into the new reality.
Peter Garnry,
Head of Equity Strategy
New alliances and collaborations outside of China may lead to prosperous times in Asia.
Charu Chanana,
Market Strategist
For years, it was thought that the balanced portfolio was a thing of the past. But recent developments may have changed that.
Peter Siks,
Investment Coach
Following a dramatic and volatile 2022 with good returns, a lot of this year's commodity performance may be driven by Chinese politics.
Ole S. Hansen,
Head of Commodity Strategy
2023 could be a tough year for currencies but EUR and JPY may have some upside.
John J. Hardy,
Head of FX Strategy
The commodity-heavy Australian market may have a good start to 2023, as the Chinese focus on growth signals demand for Aussie resources.
Jessica Amir,
Market Strategist
From a near-perfect environment for speculative assets before 2022 to the opposite, crypto faces fundamental challenges.
Mads Eberhardt,
Cryptocurrency Analyst
Disclaimer
The Saxo Bank Group entities each provide execution-only service and access to Analysis permitting a person to view and/or use content available on or via the website. This content is not intended to and does not change or expand on the execution-only service. Such access and use are at all times subject to (i) The Terms of Use; (ii) Full Disclaimer; (iii) The Risk Warning; (iv) the Rules of Engagement and (v) Notices applying to Saxo News & Research and/or its content in addition (where relevant) to the terms governing the use of hyperlinks on the website of a member of the Saxo Bank Group by which access to Saxo News & Research is gained. Such content is therefore provided as no more than information. In particular no advice is intended to be provided or to be relied on as provided nor endorsed by any Saxo Bank Group entity; nor is it to be construed as solicitation or an incentive provided to subscribe for or sell or purchase any financial instrument. All trading or investments you make must be pursuant to your own unprompted and informed self-directed decision. As such no Saxo Bank Group entity will have or be liable for any losses that you may sustain as a result of any investment decision made in reliance on information which is available on Saxo News & Research or as a result of the use of the Saxo News & Research. Orders given and trades effected are deemed intended to be given or effected for the account of the customer with the Saxo Bank Group entity operating in the jurisdiction in which the customer resides and/or with whom the customer opened and maintains his/her trading account. Saxo News & Research does not contain (and should not be construed as containing) financial, investment, tax or trading advice or advice of any sort offered, recommended or endorsed by Saxo Bank Group and should not be construed as a record of our trading prices, or as an offer, incentive or solicitation for the subscription, sale or purchase in any financial instrument. To the extent that any content is construed as investment research, you must note and accept that the content was not intended to and has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such, would be considered as a marketing communication under relevant laws.
Please read our disclaimers:
- Notification on Non-Independent Investment Research (https://www.home.saxo/legal/niird/notification)
- Full disclaimer (https://www.home.saxo/en-gb/legal/disclaimer/saxo-disclaimer)
