(Bloomberg) — A major pandemic-era distortion in the world of finance is all but over — and the new normal is helping to fuel the worst cross-asset sell-off in decades.
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After being trapped in negative territory during the lockdown days, inflation-adjusted Treasury yields have rebounded, with the five- and 10-year measures returning near multi-year highs.
In another sign that the era of free money is over, short-term real interest rates suddenly jumped this week to their highest level since March 2020 after finally turning positive in early August.
This is all bad news for money managers everywhere, with interest-sensitive allocations harder to justify from tech stocks to long-maturity corporate bonds. Rising real yields — seen as the true cost of money to borrowers — are roiling the economy as mortgage rates rise as Corporate America adjusts to higher costs of doing business.
It could get a lot worse. The thinking among Wall Street traders is that the hawkish Federal Reserve is increasingly determined to create tighter financial conditions — through lower stock prices and still higher bond yields — to struggling with rampant inflation.
That suggests investors in nearly every asset class are risking new market chaos as Goldman Sachs Group Inc. predicts that 10-year real yields are approaching levels that would significantly constrain economic activity.
“The next few months for equities will be volatile and there is a risk of further absorption if this dynamic of rising real yields with slowing growth continues,” said Christian Müller-Glissmann, managing director of portfolio strategy and asset allocation at Goldman Sachs .
The latest spike in yields, with echoes of the June turmoil, began when Powell surprised investors at the Jackson Hole Symposium with a gloomy message that borrowing costs would need to rise and remain in potentially growth-limiting territory to tame inflation. Since then, U.S. 10- and five-year real interest rates have risen about 30 and 38 basis points, respectively, while the tech-heavy Nasdaq 100 has tumbled 8%.
“Any push to new multi-year highs in real yields is likely to be matched by another leg down in stocks,” said Charlie McElligott, cross-asset strategist at Nomura Holdings Inc.
Rising inflation-adjusted yields are putting pressure on tech stocks, as the latter’s long-term earnings prospects must now be discounted at higher rates. At the same time, assets devoid of income streams, such as gold and cryptocurrencies, appear less attractive given the higher opportunity costs of holding them compared to government bonds that pay real returns.
“There is clear competition from higher real bond yields for any type of stored value, especially more speculative, long-term,” Muller-Glissmann said.
It’s all a world away from the post-financial crisis era, when central bankers sought to reshape the economy through historically low interest rates that sent money managers into increasingly riskier assets to extract profits.
These days, monetary officials are believed to be effectively seeking to anchor real interest rates higher to help moderate the excesses of the inflation-addled business cycle.
In an interview on Bloomberg’s Odd Lots podcast after Jackson Hole, Minneapolis Federal Reserve President Neal Kashkari noted that real interest rates are a driver of economic growth. He also did not rule out a scenario where inflation fails to reach the central bank’s target any time soon, requiring higher borrowing costs.
Yet policymakers must tread carefully. The yield on 10-year inflation-protected securities is now less than 30 basis points away from the 1% tipping point that would begin to seriously hurt economic growth, according to a Goldman Sachs analysis. And while the latest jobs report may give ammunition to those who believe the Fed can deliver a soft landing, the skeptics clearly outnumber the optimists right now.
“A lot of the economic data looks really uncertain, so the usual offset to higher real interest rates — the economic optimism — is just not there,” Morgan Stanley’s chief cross-asset strategist Andrew Sheets said in an interview with Bloomberg TV. “It still puts the market in a difficult position.”
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