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Rise in Real Yields a Key Driver in Risk Assets - TheStreet

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Date: 2022-07-07 17:04:43

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In the fall of 2021, against the backdrop of persistent inflation, the U.S. Treasury market began to price in a dramatically changing interest rate environment and a Federal Reserve pivot to aggressive tightening. The Fed began to outline its plan for moving short-term interest rates higher with hikes to the Fed Funds rate and for the cessation of long-duration asset purchases and a roll-off of bonds on their balance sheet.

Rate hikes were believed to begin in the first quarter of 2022, and quantitative tightening would begin in June. The impact of this messaging was swift. In October 2021, 2-year U.S. Treasury yields were at .26% and six months later moved up to a high near 3.4%. In addition, 10-year U.S. Treasury yields rose from 1.4% to 3.4% in the same time period.

Perhaps more importantly, “real yields” in the 10-year have risen from a low of negative 110 basis points to a current level of positive 50 basis points. Real yields are calculated by subtracting 10-year inflation expectations from the current nominal yield. When these rates are positive they tend to compete for investment dollars against both equities and business investment.

I spoke to Subadra Rajappa, head of U.S. Rates Strategy for Societe Generale. “The rise in real yields has been quite dramatic and that has to have an impact in tightening financial conditions,” she said. “We are seeing that in equity markets, widening corporate bond spreads, and it’s definitely a key driver in risk assets.”

When Fed policy shifts to hawkish, the obvious goal is to remove liquidity from the monetary system in hopes of cooling the demand that is currently out of balance with insufficient supply. Of course, this path doesn’t come without significant risk. If the Fed overshoots its policy goal it can result in prolonged negative GDP growth.

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Soft Landing Possible?

But can the Fed cool the economy and engineer a soft landing and not a recession? Rajappa is not convinced. “As it stands, I don’t see any strong signals of a recession as corporate profit margins are still pretty healthy. Down the line, when the Fed has delivered another 200 basis points of rate hikes, that will be when you’ll see pressure on the yield curve and that’s when you’ll see a recession.”

She also added that “this year the Fed is singularly focused on inflation up to the point where I think they get the Fed Funds rate up to 2.5% to 3%. Beyond that, that they will be concerned with tightening financial conditions, and perhaps they will take a more balanced approach.”

Fed Balance Sheet Reduction

The Fed’s “quantitative tightening” or balance sheet reduction began in mid-June and is set to ramp up to a reduction of $95 billion per month by September. On QT Subadra believes that “the Fed stepping away (from treasury purchases) will have an effect on demand dynamics. We saw choppy price action in Treasuries even as the Fed began to taper asset purchases” and “we will need to see domestic and foreign buyers step in to replace that demand.”

Rajappa does not see an aggressive spike in 10-year U.S. Treasury yields and has a target of 3.25% for the first half of 2022 with a move lower towards the end of the year as the Fed Funds rate gets closer to 3%.

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Original Source: https://www.thestreet.com/investing/futures/rise-real-yields-key-driver-risk-assets