The era of cheap debt might be over, and it can lead to a big shift for investors. That was the take from BMO Capital Markets, which took a dive into sell-off triggered by rising long-term yields. They found the rising yields aren’t due to rising inflation expectations, but rising real yields across the world. Many of the factors that produced the easy credit environment since the Global Financial Crisis are now reversing. The bank doesn’t see a major risk event, but assets boosted by easy credit will need to correct. Yes, that includes real estate. *gasp*
Real Bond Yields Are Returning To Their Natural State
For those unaware, bond yields are the return an investor gets from its interest payments. Real bond yields are these returns adjusted for inflation. A bond with a 7% yield sounds great to people in Canada by itself. However, in a country where there’s an 8% inflation rate, a bond offering that yield would produce a loss in buying power. Who wants to lose money? No one… except for governments and central banks.
Since investors try to avoid losses, rising inflation expectations typically drive yields. BMO’s dive into the data revealed this is one of those exceptions. They found the US 10-year breakeven rate hovered around a narrow range of 2.3% over the past year. That implies long-term inflation expectations have been relatively stable.
What’s driving the recent market sell off is rising yields for long-term rates. The bank’s research reveals the real 10-year Treasury yield is closing in on 2% for the first time since 2009. They also emphasize that all other yields have surpassed that rate.
“To put today’s levels in perspective, the 10-year real yield was basically at zero just before the pandemic, and promptly dropped deeply negative for the next two years— at least until the Fed started tightening and engaging in QT,” explains Robert Kavcic, senior economist at BMO.
For those not fluent in bankster, it’s important to note that supply and demand impacts credit. As the global reserve currency, the Global Financial Crisis led to a “flight to safety” for US dollars. At the same time, demand for loans fell, leading to a healthy supply of cash. That made credit very easy, right into the pandemic—when credit was further flooded. As the global reserve currency, this influences virtually every market.
Real Yields Are Rising Across The World
As the world returns to pre-Global Financial Crisis conditions, yields are responding. To help curb inflation not seen since the 1980s, central banks are basically doing 2008 in reverse. Hiking rates and removing liquidity they injected, they’re lowering the supply of credit. Since it’s a market, interest costs rise as borrowers compete for capital.
“The ball really got rolling in early 2022, when central banks and markets collectively realized how far policy had fallen behind the inflation curve, and tightening commenced. Instead of buying bonds, central banks are now busily reducing their massive holdings,” says Kavcic.
He cites other factors piling on, such as Fitch’s Aug 1 downgrade, and the US budget deficit hitting $2 trillion. In addition, the bank notes that rising geopolitical tensions play a role.
“Geopolitics may be playing a small role, as Russia has essentially cut its holdings of Treasuries to nil and China is seemingly headed in that direction, reducing its holdings by $265 billion since the first quarter of 2021 to $835 billion now (a 24% slice)…Even Japan, again the largest holder of Treasuries, has trimmed its exposure by 10% in the past year to $1.1 trillion, as domestic JGBs now offer a semi- respectable 0.63% 10-year yield.”
In plain english, that’s a further weaning of credit suppliers. The rising demand drove yields lower post-Global Financial Crisis, and persisted until post-pandemic? It’s now reversing, helping to push yields higher.
The New Normal Is The Old Normal
Market conditions may sound unusual and negative if you can’t remember before 2008. In fact, certain industries where a “new normal” mindset formed may see headwinds. However, zooming out looks like the post-2008-to-2022 era was the unusual period. The conditions we’re seeing now are more like they used to be, before the global economy imploded.
“The rise in real yields back to levels that were pretty much the norm prior to the Global Financial Crisis may be a clear signal that the long-term rate outlook has truly shifted,” says Kavcic.
The banks expects rising real rates to notably impact public spending, household borrowing, and asset values. All three of these experienced easy growth, and it’s easy to see why. How could demand not be excessive if the loan value eroded over time, dumping liabilities on bond holders?
Easy money fading is expected to produce more historically-typical conditions. We’re already seeing politicians discuss more balanced spending in some economies. Households are also pumping the breaks on borrowing. The impact on asset valuations is going to be a more difficult pill to swallow.
“Asset valuations will ultimately need to readjust to a different world for real interest rates—real estate (yes, including housing), equities (which arguably have already partially adjusted through last year’s bear market), and more speculative assets,” writes Kavcic.
It’s not all negative headwinds. BMO sees at least two winners in a rising real rate environment—pensions and savers. Remember savings? It’s where good money that should have been invested went to die over the past decade. It wasn’t always like that.
More predictable and stable fixed income returns can also mean less risk pursuit. Avoiding a loss of purchasing power from negative real rates requires more risk. If the average person needs to pursue significant risk just to seek stability, excess speculation can easily occur.
A return to positive real yields is a big shift from today. However, it’s closer to the baseline of history than the past decade or so has been.
On #TeamRecession, and think the economy might not be able to support it? Despite frequent recession talk, the bank is having a hard time finding signs in the US. They point to the Atlanta Fed’s GDPNow forecast, which estimates Q3 at 5.8% growth.
“…Which, you know, is a pretty long way from recession,” quips Kavcic.
Most analysts and economists that see a recession, only expect it to be mild to moderate. It may only sound extreme if asset values need to correct, and consumers have to slow borrowing.
