Real return environment… The rise in real interest rates in the US is followed. The Fed's hawkish policy stance provided a notable return in 10-year real returns, which were below minus 1% in March after Russia's invasion of Ukraine. Fed officials increased benchmark rates by a quarter point last month. In an important step towards pre-pandemic normalcy, the tendency of 10-year nominal returns to exceed inflation is an important threshold.
US 10-year real returns… Source: Bloomberg
Bond yields and policy rate projections… Fed officials increased benchmark rates by a quarter point last month and are signaling a relatively rapid rate of increase for the rest of the year. With an aggressive increase in US 10-year Treasury yields, we are testing above the 2.90% level. The recent rate hikes in the US have turned real interest rates positive after a long hiatus. After this point, stability will be important. As of the current outlook, we know that the Fed will enter a rapid tightening process, far from the 2% inflation target.
Swap traders are pricing in about 140bp gains at the next three Fed meetings, signaling they expect at least two 50bp moves. The US central bank last increased by 50 basis points or more in a row in August 1984.
Comparison of US 10-year bond yield, 10-year inflation break-even rate and CPI… Source: Bloomberg
Economic impact… A record increase in borrowing costs could slow the economic recovery. As economies recover and inflation accelerates, governments exit extraordinary support policies, the effects of tight fiscal and monetary policy on consumers and businesses will be in question. At this point, in order for the Fed to act more comfortably, the improvement in growth should continue and company balance sheets should continue to be profitable. In order to avoid the troubling effects of the rapid tightening of monetary policy, it is important to reduce the risks of a hard landing in the economy.
Conclusion? Inflation-adjusted returns have been negative for nearly two years, providing substantial support for stocks. Rising real returns eat up positive ground for risk assets, threatening stock valuations and their relative appeal to bonds. As inflation hit its fastest pace in four decades and the Fed reacted, the 10-year yield nearly doubled from 1.51% on Dec. There's plenty of room for higher returns, given that the 10-year break-even rate, which expresses the expectation of inflation, is 3% and this month's data shows annual inflation soaring to 8.5% in March.
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