As boring as the sideways trend in U.S. Treasury yields since April of this year may look, it becomes more exciting below the surface if one breaks yields down into their two components, real yields and inflation expectations.
Inflation expectations initially plummeted during the coronavirus crisis before recovering steadily from their low in March. Currently, the implicit inflation expectation is above 1.6% per annum over the next ten years – only slightly below the average of the past five years. Real yields, in turn, have continued their decline and have even undercut their previous record low from the global financial crisis – in August they fell to a level as low as -1.1%.
In theory, real yields should reflect growth expectations. Therefore rising inflation expectations combined with falling real yields would imply that the market expects the economy to slide into stagflation.
We would, however, be cautious with this interpretation. This is because in recent years the bond market's ability to predict the growth path or to tame overheating economies or overspending governments has frequently been undermined. Several factors have contributed to this, first and foremost the huge central-bank buying programs. That the existence of a buyer who pursues not price targets but quantity targets distorts prices is undisputed. Implicitly, central-bank purchases therefore have an impact on real interest rates, weakening their ability to signal growth expectations. Instead, the real interest rate has become the central bank's instrument for stimulating consumption and investment.
For investors who are concerned about the potential inflationary consequences of massive central-bank interventions, inflation-indexed bonds and gold may be suitable hedging instruments, says Jörn Wasmund, Head of Fixed Income at DWS.
* 10-year maturity
** Break-even inflation rate as derived from the differential between nominal and real U.S. Treasury yields
Sources: Federal Reserve Bank of St. Louis, DWS Investment GmbH as of 8/11/20