(Bloomberg) — A major pandemic-era distortion in the financial world is over — and the new normal is helping fuel the worst cross-asset rally in decades.
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After being trapped in negative territory during the lockdown days, inflation-adjusted Treasury yields are breaking out again, with five-year and 10-year measures returning to near multi-year highs.
In another sign that the era of free money is over, short-term real interest rates suddenly jumped this week to their highest since March 2020 after finally turning positive in early August.
This is all bad news for money managers around the world, as interest rate allocations are harder to justify from tech stocks to long-dated corporate bonds. Rising real yields — considered the true cost of money to borrowers — are rippling through the economy as mortgage rates soar and Corporate America adjusts to the higher cost of doing business.
It could get a lot worse. The thinking among Wall Street traders is that the Fed is increasingly determined to tighten financial conditions – through lower stock prices and even higher bond yields – in order to combat raging inflation.
That suggests investors in nearly every asset class are risking new market chaos as Goldman Sachs Group Inc. predicts that 10-year real yields are moving closer to levels that would substantially curtail economic activity.
“The coming months for equities will be bumpy and there is a risk of further draws if this momentum of rising real yields continues with slowing growth,” said Christian Mueller-Glissmann, managing director of portfolio strategy and asset allocation at Goldman Sachs.
The latest rise in yields in the wake of June’s jitters began when Powell surprised investors at the Jackson Hole conference with a gloomy message that borrowing costs would have to climb higher and remain in potentially growth-shrinking territory to reduce inflation. Since then, real U.S. 10- and five-year yields have advanced about 30 and 38 basis points, while the tech-heavy Nasdaq 100 has fallen 8 percent.
“It’s likely that any push to new multi-year highs in real yields would likely be matched by another decline in equities,” said Charlie McElligott, cross-asset strategist at Nomura Holdings Inc.
Rising inflation-adjusted yields are putting pressure on stocks like tech stocks because the latter’s long-term earnings prospects must now be discounted at higher interest rates. At the same time, assets that have no income streams like gold and cryptocurrencies look less attractive given the higher opportunity cost of holding them compared to a real-yielding Treasury bond.
“There is clear competition from higher real bond yields for every type of store value, especially more speculative, long-dated,” Mueller-Glissmann said.
All this is a world away from the post-financial crisis era, when central bankers tried to revive the economy through historically low interest rates that sent money managers into riskier and riskier assets in order to turn a profit.
These days, the thinking is that monetary officials are essentially seeking to stabilize real interest rates higher to help contain the business cycle excesses that inflation brings.
In an interview on the Bloomberg Odd Lots podcast after Jackson Hole, Minneapolis Fed President Neel Kashkari noted that real interest rates are a driver of economic growth. He also did not rule out a scenario in which inflation falls short of the central bank’s target any time soon, requiring higher borrowing costs.
However, policymakers must tread carefully. The yield on the 10-year inflation-protected note is now less than 30 basis points away from the 1% threshold that would begin to seriously hurt economic growth, according to analysis by Goldman Sachs. And while the latest jobs report may give ammunition to those who believe the Fed can secure a soft landing, the skeptics clearly outnumber the optimists right now.
“A lot of the economic data looks really uncertain, so the usual hedge against higher real interest rates — economic optimism — just isn’t there,” Morgan Stanley chief strategist Andrew Sheets said in an interview with Bloomberg. TV. “This still puts the market in a difficult position.”
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