Analysis |  Real returns are the market's whopper

Analysis | Real returns are the market’s whopper


When you are having radiation therapy for prostate cancer, you need to drink plenty of water to keep your bladder ‘comfortably full’. Sitting in the hospital awaiting my treatment with clenched teeth, I pondered, not for the first time, how the meaning of the word “comfortably” was stretched past the breaking point when an elderly man turned to me and asked if I was Richard Cookson. I was extremely touched and impressed that my former philosophy teacher recognized me. It had, after all, been almost 40 years since we last saw each other.

I was also a little ashamed that he recognized me first. He is one of the most admirable people I have ever met. In the tutorials, he would listen carefully to carefully constructed (or so I hoped) arguments with a scintillating kind of benevolence before tearing them down with the slightest question. To his surprise, I said philosophy was the most useful subject I had studied because it taught me to question and reflect.

Much of what people think and write about in financial markets doesn’t hold up to scrutiny. Forward-looking measures of real returns are something central bankers and markets have been working on lately. Although I have written about them myself, I am increasingly of the opinion that they are about as meaningful as that word “comfortably”.

Real returns represent the difference between the rate of inflation and interest rates. Positive real returns occur when interest rates are above inflation and negative real returns when the opposite occurs. Real returns are reasonably easy to measure after the fact (what economists call ex post). You look at interest rates and inflation over a period of time and see if the former compensated you for the latter. Measures of current real rates are a variant of this: you compare the lagged rate of inflation with current interest rates. So despite central bank rate hikes, the latest from the European Central Bank last week, current real rates are still massively negative everywhere because inflation is so much higher than interest rates.

Pretty simple stuff so far. Future real returns (ex ante) are much more interesting but much more problematic. The real forward yields everyone is looking at are the real yields of inflation-linked government bonds, although many are smaller in terms of stock and illiquid. The most liquid and studied are those issued by the United Kingdom and the United States.

These are real in the sense that these instruments provide a coupon plus 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 life of the bond, their excitement about how much they are willing to pay for these flux is the actual yield. Many people think that the size of these fluctuations gives an idea of ​​whether or not monetary policy is tightening. Inflation-linked bonds also give an idea of ​​expected inflation, simply by subtracting the actual yield from the yield of a conventional bond of the same maturity. Part of the reason governments issue inflation-linked bonds is so policymakers can track both measures.

In recent months, the rapid rise in real yields combined with falling inflation expectations has caused many people – including central bankers – to wonder whether central banks are in danger of pressing the monetary brakes too hard. . Strategists and economists in the financial firmament have pored over this combination and warned of the resulting dangers. Part of my problem is that they got it so obviously wrong. At the start of 2020, the market’s best estimate was that US inflation would be 0.22% over the next five years. Inflation has been much higher and real rates, therefore, much lower. More problematic is that these results don’t mean what people think they mean and in recent years they have become increasingly misleading.

Take actual rates. Many have argued that the huge drop in the price of inflation-linked bonds in the UK and US over the past year was due to rising real rates. This is trivially true but very misleading. It is much more accurate to say that real rates have risen due to investors selling off inflation-linked bonds. The rise in real yields has nothing to do with a monetary policy that has become too restrictive. To be honest, I’m not really sure what that tells you, other than the fact that they had gotten horribly expensive and the biggest pool of potential buyers were also the ones who needed to sell.

On the other hand, as I said, inflation expectations simply measure the difference in yield between conventional bonds and inflation-linked bonds. The number is more accurately called the breakeven inflation rate. This is the rate at which, given current information, investors are indifferent to buying inflation-linked bonds or government bonds of the same maturity. But all of these true-by-definition exits mean even less when conventional bond yields have been manipulated so much lower by central banks, in quantitative easing or by hoarding foreign exchange reserves. I guess central banks globally hold something like $35 trillion in public debt.

If conventional bond yields cannot rise as much as they should because there are not enough of them, it follows that, in the face of the massive selling off of inflation-linked bonds, yields balance will drop. That tells you a lot more about the scarcity of conventional bonds around the world than it does about the likely path of inflation, central bank credibility, or anything else. None of this is to say that inflation won’t come down, just that, as my tutor might have said, movements in real rates or breakeven inflation don’t tell you anything interesting anyway. More from Bloomberg Opinion:

• The Fed should think in terms of a trilemma: Mohamed El-Erian

• Whatever you do, don’t mention the pivot: Daniel Moss

• Biden hurt, not helped, the economy: Allison Schrager

This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.

Richard Cookson was Head of Research and Fund Manager at Rubicon Fund Management. Previously, he was Chief Investment Officer at Citi Private Bank and Head of Asset Allocation Research at HSBC.

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