The acceleration in real rates is about to become a problem for risky assets

Investors are unwilling to take on inflation protection securities as the Federal Reserve becomes more aggressive and inflation expectations are adjusting lower. Today, the 10-year breakeven rate is recording the biggest drop since January last year, provoking an acceleration in real yields that are taking them close to test resistance at -0.5%.

Although risky assets show more resilience than instruments that carry high duration, we expect things to change as real rates break resistance at -0.5% and rise quickly to -0.35%. Indeed, by that time, 30-year TIPS yields would have already turned positive, indicating that financing conditions are tightening fast, threatening risky assets.

So far, duration has been a bigger villain than credit quality. Year to date, US Treasuries with 20+years maturity (TLT) have fallen -4.2%, investment grade USD bonds (LQD) dropped -3.4%, and emerging market hard currency bonds (EMB) -3.7%. At the same time, junk bonds that carry much shorter durations have proven more resilient, with junk in the US (HYG) falling -1.8% and Europe (IHYG) only -1.1%.

However, next week's FOMC meeting could support real rates if the Fed doesn't sound as hawkish as the market expects. So far, the market is pricing four interest rate hikes, with some market players expecting two rate hikes in the March meeting. Any indication of fewer hikes might produce a drop in nominal yields and a rise in breakeven rates, translating into lower real rates.