One by one, the guardians of monetary probity are giving up cheap money, either because they choose to or because a falling currency forces them to do so. Soon enough, the aberration of negative interest rates will go down in the history books and normal operations will resume.
Borrowing money has a cost, and if you’re lucky enough to borrow something, you’ll be rewarded for it. It’s a better place for us, but going back there after 15 years in the mirror world of free money will be painful.
There is eternal hope for investors, especially in the stock market where the default setting is to look for the silver lining. But the penny is also dropping for stock market investors. The next year or so will be tough for companies and investors at a time of deliberate demand destruction and rising costs.
Somewhat belatedly, stock buyers are catching up with the bond market, where people are more apt to see the cloud around that silver lining.
One of the most notable features of the post-financial crisis era, and a key driver of the long equity bull market, has been central banks’ maintenance of negative real yields.
Keeping bond yields below expected inflation was specifically designed to push investors into riskier assets in search of acceptable yields. If you’ve lost inflation-adjusted money holding cash or bonds, the logical move was to switch your money to stocks.
Real yields fell deep into negative territory during the pandemic as inflation expectations rose while central banks kept interest rates, and hence bond yields, artificially low. Two things have happened in the last few months that are dramatically reversing this situation.
First, as we know, and as this week’s announcements confirm, central banks have re-learned their primary purpose. Second, inflation expectations are starting to fall as investors understand what this policy shift means – a recession may not be the desired outcome, but it will be acceptable to independent central banks if that’s what it takes to keep inflation on track to turn your head.
With inflation still in the high single digits on both sides of the Atlantic, it may seem unlikely that inflation will fall back on central bank targets, but that is exactly what financial futures markets are suggesting.
A measure of investors’ expected 10-year inflation, derived from the yield differential between inflation-linked and nominal bonds, has fallen from 3 percent to 2.4 percent in just five months. Investors are starting to take central banks at their word.
At the same time, investors are now expecting this week’s rate hikes to continue for the foreseeable future. By next spring, US interest rates are expected to hit 4.6 percent. Bond yields are now reflecting this reality, with yields on bonds maturing in two years now exceeding 4 percent.
Far from keeping bond yields well below the expected inflation rate, they are now well above it. The squeeze is real in the truest sense of the word.
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