Federal Reserve Chair Jerome Powell has likely heard it all about negative U.S. real yields: How they’re devastating for pensions and life insurers, causing equity valuations to outpace the economic recovery, encouraging a stampede into gold and out of the dollar and giving the green light for American companies to gorge on cheap debt once again.
The message he and his colleagues are likely to convey at their meeting this week: That’s all fine with us.
For months now, the benchmark 10-year U.S. Treasury yield has been stuck around 0.6%. Bond traders have had little reason to wager it’ll change much, given that the Fed is still purchasing $80 billion of Treasuries each month and keeping the door open to yield-curve control, which would ensure that short-term rates are pinned near zero. Meanwhile, the market’s inflation expectations for the coming decade have marched gradually higher in the wake of fiscal relief efforts across the globe, reaching 1.5% last week for the first time since February.
The difference between the two is the “real” 10-year U.S. yield. Last week it fell to -0.93%, breaking through the all-time low closing level of -0.92% set in December 2012, which was part of an unprecedented 382-trading-day stretch from November 2011 to June 2013 in which the inflation-adjusted 10-year yield never closed above zero.
Sub-Zero Guarantee
If the Fed has its way, the current 87-day streak of negative real yields should easily last at least 300 more days — if not longer — to smash that record. Bank of America Corp. strategists are among those who say real rates could drop to -1% if the coronavirus pandemic looms over the economic recovery and encourages central bankers to strengthen their forward guidance.
The first part of that criteria has already happened, as the Sun Belt has grappled with its own wave of Covid-19 outbreaks just as the earlier-hit Northeast states finally started reopening. The second part about enhanced forward guidance has been out in the open too, at least for those who closely monitor Fed speakers. It’s clear that there’s a growing consensus among the central bank’s leaders that they should commit to keeping interest rates near zero until actual inflation reaches — and preferably exceeds — their 2% target.
Fed Governor Lael Brainard recently expressed support for this strategy. So did Philadelphia Fed President Patrick Harker, who said in a Bloomberg Television interview with Michael McKee: “I’m supportive of the idea of letting inflation get above 2% before we take any action with respect to the fed funds rate.” Chicago Fed President Charles Evans and Dallas Fed President Robert Kaplan have said they’re open to overshooting the target. Even before the economy faltered, Powell said he and his colleagues wanted to “send a clearer signal that we’re not comfortable with inflation running persistently below our 2% symmetric objective.”
Based on the latest Federal Open Market Committee meeting minutes, a “number” of officials favor tying future policy moves to inflation, compared with “a couple” preferring to link future moves to the unemployment rate and “a few others” favoring the typical calendar-based forward guidance. It’s looking more and more like the “number” will prevail. My Bloomberg Opinion colleague Tim Duy appropriately called it “a whole new ballgame” for monetary policy.
It’s also uncharted territory for U.S. bond traders. The concept of negative interest rates has been a staple of the global debt market for years now, of course. But it has mostly been confined to yields, both real and absolute, for sovereign debt investors in Germany and Japan, or the yield on Treasuries for those investors after hedging for currency risk. Negative real yields in the U.S., by comparison, are a rare phenomenon. Since the 2013 “taper tantrum,” the 10-year inflation-adjusted rate has only dipped below zero a few times, and never for very long.
From mid-2013 through the start of this year, long-term Treasuries always indicated skepticism about a sharp rise in inflation. Real 10-year yields only increased above 1% for a fleeting stretch in late 2018, after which the Fed proceeded to cut interest rates. It’s certainly possible that a meaningful change to the central bank’s framework will convince traders that sharper price growth really is coming in the near future. All else equal, those kind of expectations would lead investors to sell Treasuries, pushing benchmark yields higher.
All is not equal, however. The Fed has given no indication it’s anywhere close to stepping back from buying Treasuries and mortgage-backed securities, and it has shown in the past through Operation Twist that it won’t hesitate to flex its muscles to depress longer-term rates. On the short end, while I’m not convinced policy makers will actually go forward with yield-curve control, it’s certainly still on the table. Under those kinds of conditions, even if inflation starts to run hot, just how high can U.S. nominal yields climb? Not enough to turn real yields positive, it would seem.
To summarize, the Fed has three options to further bolster the U.S. economy, whether at this week’s meeting or at September’s, or even later this year:
- Tying future rate increases explicitly to actual inflation reaching or overshooting 2%.
- Yield-curve control out to three or five years.
- Adjusting Treasury purchases to mainly buy longer maturities.
Any one of these would support negative real yields — all three would guarantee them. Call it the next frontier in financial repression if you want, Powell and his Fed colleagues don’t mind. Before the last FOMC meeting, I wrote that Powell and his colleagues need a better answer on the consequences of asset inflation and that I’d press the Fed chair on this topic if I were asking questions. Well, McKee did ask that, and Powell predictably bristled:
“So we’re not looking to achieve a particular level of any asset price. What we want is investors to be pricing in risk like markets are supposed to do. Borrowers are borrowing. Lenders are lending. We want the markets to be working. And, again, we’re not looking to a particular level.”
I’m not sure he could say the same thing about real yield levels. I’d like to hear what risks, if any, Powell envisions from monetary policy ensuring that sub-zero inflation-adjusted Treasury yields become a permanent fixture of U.S. markets.
Whether he says so or not, bond traders should treat rock-bottom real yields as a feature, not a bug, of the Fed’s strategy. Anyone still expecting the fixed interest payments from Treasuries, or even high-quality corporate bonds, to outpace inflation in the coming years is just setting themselves up for disappointment.
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