By Jamie McGeever
ORLANDO, Florida (Reuters) – TRADING DAY
Making sense of the forces driving global markets
By Jamie McGeever, Markets Columnist
Softer bond yields cushion stocks
Cooler inflation pressures in the shape of surprisingly soft U.S. economic data and a slide in oil prices helped bring down Treasury yields and support stocks on Thursday, although the recent surge on Wall Street does appear to be losing steam.
In my column today I look at how the decline in U.S. inflation – a healthy development, in most people’s eyes – is coming with an unwelcome side effect – rising real yields. More on that below, but first, a roundup of the main market moves.
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If you have more time to read, here are a few articles I recommend to help you make sense of what happened in markets today.
Today’s Key Market Moves
Inflation – calm before the storm?
A decline in European and U.S. bond yields provided the springboard for equity markets on Thursday. Or at least a cushion.
Thursday’s U.S. bond market rally will also have come as relief to policymakers in Washington as yields pulled back sharply across the curve, but not before longer-dated yields hit fresh one-month highs. The 10-year yield hit 4.55% and the 30-year yield reached 5.00% before sliding back.
The recovery in global stock prices since the ‘Liberation Day’ tariff debacle early last month has been impressive, but understandably, that momentum is fading. For that momentum to be rekindled, a further decline in bond yields may be required.
Although figures this week showed U.S. consumer and producer inflation cooled in April, tariffs have yet to bite and price pressures are tilted to the upside.
Worries about the U.S. public finances are intensifying too. The Trump administration’s plans to extend tax cuts, coupled with what many analysts consider to be a lack of commitment to reduce spending, will widen the budget deficit, perhaps to more than 7% of GDP.
Add to that the apparent desire among foreign investors to reduce their exposure to U.S. assets, and Treasuries’ safe haven allure has been diminished. Just when the deficit is widening.
All of this means the ‘term premium’ – the extra compensation investors demand to hold longer maturity Treasuries rather than rolling over short-dated ones – is near the highest in over a decade. The yields on 10- and 30-year bonds are now not too far away from levels that were the norm before the Global Financial Crisis.
Previous spikes in the term premium have cheapened bond prices sufficiently to attract overseas money back into the market, especially the 7-10 year part of the Treasury curve, says Bank of New York’s John Velis. But this hasn’t happened this time around, suggesting yields may have further to rise.
It’s notable that the 30-year yield fell only 5 basis points on Thursday, 3-4 basis points less than any other point on the curve.
Meanwhile, the main focus for investors in Asia on Friday will be Japan’s first quarter GDP figures. Economists polled by Reuters expect an annualized contraction of 0.2%, which would be a significant drop from the 2.2% expansion the previous quarter and the first in a year.
These are backward-looking numbers but the immediate outlook is highly uncertain, at best – the tariff turbulence has put the yen back under pressure and has, according to many analysts, put the Bank of Japan’s rate-hiking cycle on ice.
US inflation progress stokes real yield problem
Few would find fault with the steady, gradual decline in U.S. inflation, but it has recently come with an unwelcome side effect: rising ‘real’ borrowing costs.
With the Federal Reserve’s official policy rate on hold and the benchmark 10-year Treasury yield edging higher, inflation-adjusted interest rates – so-called real rates – are rising, effectively tightening monetary policy and financial conditions.
The real yield on the 10-year Treasury note is now approaching 2.20%, the highest in a decade, based on the April headline annual CPI inflation rate of 2.3%. And the real fed funds rate has risen from a low of 1.50% in January to eclipse 2.00%, the highest in more than six months.
While real borrowing costs are not at levels that will trigger alarm bells with Fed officials, CEOs or CIOs, the direction of travel is pretty clear, and is one more factor that could weigh on the activity of consumers, businesses, and investors in an environment already shrouded in a thick fog of uncertainty. Additionally, for policymakers, it shines a light on the constant struggle to determine the optimal interest rate at any given time.
In Fed Chair Jerome Powell’s press conference earlier this month after the central bank left its fed funds target range on hold at 4.25-4.50%, he said no fewer than eight times that rates are “in a good place”. Current policy is “somewhat” and “modestly or moderately” restrictive, he added.
The higher real rates grind, however, the tighter policy gets, unless the Fed resumes its easing cycle, which has been on pause following cuts of 100 basis points between last August and December. The tariff-fueled uncertainty and volatility of recent months has helped to extend that pause and, thus, enabled real rates to rise.
R-STAR, MAN
Real borrowing costs can send vastly different signals from their nominal equivalents. For example, Japan’s official policy rate and long-dated bond yields are the highest in years, but the real policy rate is deeply negative and by far the lowest among the G4 central banks.
In the U.S., the signaling behind today’s rate moves is far from clear. If real yields are rising because investors are demanding a risk premium to hold dollars and Treasuries, then it’s a cause for concern. If the upward shift reflects strong growth expectations, then that’s much more positive.
But, regardless, one thing is evident. The higher U.S. real rates grind, the further away they move from ‘R-Star’, the amorphous real rate of interest that neither stimulates nor crimps economic activity when the economy is at full employment.
Two closely watched R-Star models partly constructed by current New York Fed President John Williams suggest the optimum real interest rate at the end of December was 0.8% or 1.3%, both the lowest in years. These figures will be updated for the January-March quarter at the end of this month. Fed rate-setters’ median projection for the natural real interest rate is around 1.0%, and this view will be updated next month.
These projections assume inflation at the Fed’s 2% target, which it hasn’t been for years. The R-Star concept has come under heavy criticism since the pandemic. Williams defended it in July last year, saying it is a fundamental part of all macroeconomic models and frameworks. “Pretending it doesn’t exist or wishing it away does not change that.”
But he also cautioned that R-Star should not be “overly” relied upon when setting appropriate monetary policy “at a given point in time” given the uncertainty surrounding it.
So as real rates move further away from this theoretical sweet spot, what, if anything, is the real-world impact?
Right now, financial conditions are loosening as markets calm after the market turmoil wrought by the ‘Liberation Day’ tariff tantrum last month. But if you exclude that uniquely volatile episode, conditions have been steadily tightening since September last year, Goldman Sachs’s U.S. financial conditions index shows.
Further upside for real yields from here may be limited if inflation ticks higher in the coming months as Trump’s tariffs kick in. But worries over U.S. debt and deficits are beginning to weigh on the long end of the bond market again.
As investors continue to monitor countless economic variables to determine where the U.S. economy is heading, elevated real yields are one they should watch closely.
What could move markets tomorrow?
Opinions expressed are those of the author. They do not reflect the views of Reuters News, which, under the Trust Principles, is committed to integrity, independence, and freedom from bias.
(By Jamie McGeever)
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