When you have radiotherapy for prostate cancer, you need to drink a lot of water so that your bladder is “comfortably full.” Sitting in the hospital waiting for my treatment with gritted teeth, I was mulling, not for the first time, that the meaning of the word “comfortably” was being stretched beyond the point of breaking when an elderly man turned to me and asked if I was Richard Cookson. I was hugely touched and impressed that my old philosophy tutor had recognized me. It was, after all, almost 40 years since we had last seen each other.
I was also a bit ashamed that he had recognized me first. He is one of the most admirable people I have ever met. In tutorials he sat listening intently to carefully constructed arguments (or so I hoped) with a sort of twinkly beneficence before demolishing them with the merest question. To his surprise, I said philosophy was the most useful subject I had studied because it had taught me to question and think.
Many of the things that people think and write about in financial markets don’t stand up to much scrutiny. A subject that has been exercising central bankers and markets of late is forward-looking measures of real yields. Much as I have written about them myself, I am increasingly of the opinion that they are about as meaningful as that word “comfortably.”
Real yields represent the difference between the rate of inflation and interest rates. Positive real yields occur when interest rates are higher than inflation and negative real yields are when the opposite happens. Real yields are reasonably simple to measure after the fact (what economists call ex post). You look at interest rates and inflation over a certain period and see if the former has compensated you for the latter. Measures of current real rates are a variation on this: You compare the lagging inflation rate with current interest rates. Hence, despite central bank rate increases, the latest by the European Central Bank last week, current real rates are still massively negative everywhere because inflation is so much higher than interest rates.
So far, pretty straightforward stuff. Future (ex ante) real yields are much more interesting but a lot more problematic. The forward real yields that everyone looks at are the real yields on government inflation-linked bonds, though many are smaller in terms of amounts outstanding and illiquid. The most liquid and studied are those issued by the UK and the US.
These are real in the sense that such instruments provide a coupon plus the accumulated inflation over the life of the bond. This is done slightly differently in the UK and the US, but since investors will eventually be compensated for inflation over the bond’s life, their enthusiasm for how much they are willing to pay for those flows is the real yield. Many people think that how much this goes up and down gives some idea about the tightness or otherwise of monetary policy. Inflation-linked bonds also provide a sense of expected inflation, simply by subtracting the real yield from the yield on a conventional bond of the same maturity. Part of the reason that governments issue inflation-linked bonds is so that policymakers can track both measures.
In recent months, rapidly rising real yields combined with falling expected inflations has led many - including central bankers - to wonder whether central banks are in danger of pushing too hard on the monetary brakes. Strategists and economists across the financial firmament have looked at this combination and warned about the resultant dangers. My problem is partly that they have been so demonstrably wrong. In early 2020, the market’s best guess was that US inflation would be 0.22% over the next five years. Inflation has been an awful lot higher and real rates therefore much lower. More problematic is that those outputs don’t mean what people think they mean and in recent years they have become ever more misleading.
Take real rates. Many have argued that the huge drop in the price of inflation-linked bonds in both then UK and the US over the past year was because real rates rose. This is trivially true but very misleading. It is far more accurate to say real rates rose because of the huge selling by investors of inflation-linked bonds. The rise in real yields had nothing at all to do with monetary policy becoming too tight. To be honest, I’m not really sure what it does tell you, apart from the fact that they had become horribly expensive and the biggest pool of potential buyers were also the ones needing to sell.
For their part, as I said, inflation expectations merely measure the difference in yield between conventional and inflation-linked bonds. The number is more accurately called the breakeven inflation rate. It is the rate at which, given current information, investors are indifferent to buying either inflation-linked bonds or government bonds of the same maturity. But all of those true-by-definition outputs mean even less when yields on conventional bonds have been manipulated so much lower by central banks, in quantitative easing or by accumulating foreign-exchange reserves. I would guess that central banks globally hold something like $35 trillion of government debt.
If yields on conventional bonds can’t rise anything like as much as they should because there aren’t enough around, it follows that, in the face of huge selling of inflation-linked bonds, breakeven rates will fall. That tells you far more about a scarcity of conventional bonds around the world than it does about the likely path of inflation, central bank credibility or anything else very much. None of this is to say that inflation won’t come down, merely that, as my tutor might have said, movements in real rates or breakeven inflation don’t tell you anything interesting either way.
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