{"id":190389,"date":"2023-05-16T10:30:00","date_gmt":"2023-05-16T14:30:00","guid":{"rendered":"https:\/\/ibkrcampus.com\/?p=190389"},"modified":"2023-05-16T11:29:41","modified_gmt":"2023-05-16T15:29:41","slug":"the-real-deal","status":"publish","type":"post","link":"https:\/\/www.interactivebrokers.com\/campus\/traders-insight\/securities\/fixed-income\/the-real-deal\/","title":{"rendered":"The Real Deal"},"content":{"rendered":"\n<h2 class=\"wp-block-heading\">EXECUTIVE SUMMARY<\/h2>\n\n\n\n<ul class=\"wp-block-list\">\n<li>Our economic system is ultra-financialized and dependent on leverage.<\/li>\n\n\n\n<li>That\u2019s why understanding the incentive scheme for both investors and borrowers is an important step to piece the global macro puzzle together.<\/li>\n\n\n\n<li>Real yields play a crucial role in that puzzle.<\/li>\n<\/ul>\n\n\n\n<h2 class=\"wp-block-heading\" id=\"h-detail\">DETAIL<\/h2>\n\n\n\n<p class=\"wp-block-paragraph\">Our economic system is&nbsp;<strong>ultra-financialized<\/strong>&nbsp;and&nbsp;<strong>dependent on leverage.<\/strong><br>That\u2019s why understanding the incentive scheme for both investors and borrowers is an important step to piece the global macro puzzle together.<\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><strong>Real yields play a crucial role in that puzzle.<\/strong><\/p>\n\n\n\n<p class=\"wp-block-paragraph\">Rule #1: you can\u2019t calculate real yields by subtracting today\u2019s inflation from long-term interest rates!<\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><strong>The right formula to calculate real yields<\/strong>&nbsp;is the following:<\/p>\n\n\n\n<figure class=\"wp-block-image size-large\"><img decoding=\"async\" width=\"1100\" height=\"81\" data-src=\"\/campus\/wp-content\/uploads\/sites\/2\/2023\/05\/d9bd42b7-5c23-4965-9951-491678773ff3_1350x99-1100x81.png\" alt=\"The right formula to calculate real yields\" class=\"wp-image-190393 lazyload\" data-srcset=\"https:\/\/ibkrcampus.com\/campus\/wp-content\/uploads\/sites\/2\/2023\/05\/d9bd42b7-5c23-4965-9951-491678773ff3_1350x99-1100x81.png 1100w, https:\/\/ibkrcampus.com\/campus\/wp-content\/uploads\/sites\/2\/2023\/05\/d9bd42b7-5c23-4965-9951-491678773ff3_1350x99-700x51.png 700w, https:\/\/ibkrcampus.com\/campus\/wp-content\/uploads\/sites\/2\/2023\/05\/d9bd42b7-5c23-4965-9951-491678773ff3_1350x99-300x22.png 300w, https:\/\/ibkrcampus.com\/campus\/wp-content\/uploads\/sites\/2\/2023\/05\/d9bd42b7-5c23-4965-9951-491678773ff3_1350x99-768x56.png 768w, https:\/\/ibkrcampus.com\/campus\/wp-content\/uploads\/sites\/2\/2023\/05\/d9bd42b7-5c23-4965-9951-491678773ff3_1350x99.png 1350w\" data-sizes=\"(max-width: 1100px) 100vw, 1100px\" src=\"data:image\/svg+xml;base64,PHN2ZyB3aWR0aD0iMSIgaGVpZ2h0PSIxIiB4bWxucz0iaHR0cDovL3d3dy53My5vcmcvMjAwMC9zdmciPjwvc3ZnPg==\" style=\"--smush-placeholder-width: 1100px; aspect-ratio: 1100\/81;\" \/><\/figure>\n\n\n\n<p class=\"wp-block-paragraph\"><strong>From a borrower\u2019s perspective,<\/strong>&nbsp;real yields represent the expected inflation-adjusted borrowing costs to take on more debt and leverage.<br>Why do real borrowing rate matter more than nominals?<br>That\u2019s because as a borrower if you pay 3% nominal interest rate on your debt but you expect inflation and your cash flows to grow by 4% per year, servicing your debt burden won\u2019t seem that scary.<br>It\u2019s about future inflation, not today\u2019s &#8211; and that explains the formula above.<\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><strong>Real interest rates matter for borrowers<\/strong>&nbsp;because they inform them on the expected inflation-adjusted cost they will face when taking on more debt and leverage.<\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><strong>From an investor\u2019s perspective,<\/strong>&nbsp;(risk-free) real yields represent the safest layer of inflation-adjusted returns they can make and hence set the bar for everything else.<br>If you can make 5% real risk-free return per year, your appetite to go and YOLO into some unprofitable tech name will be much lower.<br>If real yields are negative, you will be looking for alternatives to deploy your cash much more aggressively.<\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><strong>Real yields play a big role in influencing investor\u2019s asset allocation preferences.<\/strong><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><strong>Here is a stunning chart:<\/strong>&nbsp;the US real yield curve today (orange) against 2 years ago (blue) &#8211; the curve is derived using Treasury Inflation Protected Securities (TIPS) for different maturities.<\/p>\n\n\n\n<figure class=\"wp-block-image size-full\"><img decoding=\"async\" width=\"958\" height=\"668\" data-src=\"\/campus\/wp-content\/uploads\/sites\/2\/2023\/05\/3257a792-6f04-41cc-baeb-30f6c46edae1_958x668.png\" alt=\"huge difference between US real yields today and just 2 years ago\" class=\"wp-image-190392 lazyload\" data-srcset=\"https:\/\/ibkrcampus.com\/campus\/wp-content\/uploads\/sites\/2\/2023\/05\/3257a792-6f04-41cc-baeb-30f6c46edae1_958x668.png 958w, https:\/\/ibkrcampus.com\/campus\/wp-content\/uploads\/sites\/2\/2023\/05\/3257a792-6f04-41cc-baeb-30f6c46edae1_958x668-700x488.png 700w, https:\/\/ibkrcampus.com\/campus\/wp-content\/uploads\/sites\/2\/2023\/05\/3257a792-6f04-41cc-baeb-30f6c46edae1_958x668-300x209.png 300w, https:\/\/ibkrcampus.com\/campus\/wp-content\/uploads\/sites\/2\/2023\/05\/3257a792-6f04-41cc-baeb-30f6c46edae1_958x668-768x536.png 768w\" data-sizes=\"(max-width: 958px) 100vw, 958px\" src=\"data:image\/svg+xml;base64,PHN2ZyB3aWR0aD0iMSIgaGVpZ2h0PSIxIiB4bWxucz0iaHR0cDovL3d3dy53My5vcmcvMjAwMC9zdmciPjwvc3ZnPg==\" style=\"--smush-placeholder-width: 958px; aspect-ratio: 958\/668;\" \/><\/figure>\n\n\n\n<p class=\"wp-block-paragraph\"><strong>In 2021<\/strong>, US real yields were deeply negative and projected to remain so for the next decade (!).<br>Borrowers had the best time of their life as they could lock in extremely cheap inflation-adjusted borrowing costs, and investors were charged with negative real yields for the \u2018\u2018luxury\u2019\u2019 to own risk-free government bonds.<\/p>\n\n\n\n<p class=\"wp-block-paragraph\">Back then,&nbsp;<strong>it was all about TINA<\/strong>&nbsp;(there is no alternative): you have to get involved in risk assets at whatever valuations, and you have to go a step further before the herd does so &#8211; buy altcoins and unprofitable tech stocks, sell it to the next guy coming.<\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><strong>The absolute level and the rate of change in real yields are important drivers of stock market valuations.<\/strong><\/p>\n\n\n\n<p class=\"wp-block-paragraph\">As the chart below shows, if long-dated real yields are negative (blue, LHS) for a prolonged period of time people will at some point be happy to pay 30x forward P\/E (!) to pile up in the S&amp;P 500.<br>We used 5-year forward 5-year real yields to isolate market expectations in 2021 for where US real yields would have been between 2026 and 2031.<\/p>\n\n\n\n<figure class=\"wp-block-image size-full\"><img decoding=\"async\" width=\"899\" height=\"694\" data-src=\"\/campus\/wp-content\/uploads\/sites\/2\/2023\/05\/e3991978-7f91-4dd6-a0e8-5455b1476506_899x694.png\" alt=\"real yields an important driver of stock market valuations\" class=\"wp-image-190391 lazyload\" data-srcset=\"https:\/\/ibkrcampus.com\/campus\/wp-content\/uploads\/sites\/2\/2023\/05\/e3991978-7f91-4dd6-a0e8-5455b1476506_899x694.png 899w, https:\/\/ibkrcampus.com\/campus\/wp-content\/uploads\/sites\/2\/2023\/05\/e3991978-7f91-4dd6-a0e8-5455b1476506_899x694-700x540.png 700w, https:\/\/ibkrcampus.com\/campus\/wp-content\/uploads\/sites\/2\/2023\/05\/e3991978-7f91-4dd6-a0e8-5455b1476506_899x694-300x232.png 300w, https:\/\/ibkrcampus.com\/campus\/wp-content\/uploads\/sites\/2\/2023\/05\/e3991978-7f91-4dd6-a0e8-5455b1476506_899x694-768x593.png 768w\" data-sizes=\"(max-width: 899px) 100vw, 899px\" src=\"data:image\/svg+xml;base64,PHN2ZyB3aWR0aD0iMSIgaGVpZ2h0PSIxIiB4bWxucz0iaHR0cDovL3d3dy53My5vcmcvMjAwMC9zdmciPjwvc3ZnPg==\" style=\"--smush-placeholder-width: 899px; aspect-ratio: 899\/694;\" \/><\/figure>\n\n\n\n<p class=\"wp-block-paragraph\"><strong>In 2022 the Fed changed its mind,<\/strong>&nbsp;and Powell started to worry about inflation and hiked rates aggressively &#8211; he even explicitly mentioned real rates multiple times as he wanted to see them in positive territory.<\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><strong>A sharp increase in real yields (blue, LHS) led to a rapid drop in stock market valuations (orange, RHS) in 2022.<\/strong><br>As soon as investors were actually given an alternative through positive real rates on risk-free Treasury bonds, they understood there was no reason to pay frothy multiples for equities.<\/p>\n\n\n\n<p class=\"wp-block-paragraph\">A rapid change in real yields affects markets behavior, and a persistently positive or negative level of real yields slowly affects investors\u2019 preferences over time (positive real yields = less appetite for risk assets and vice versa).<\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><strong>But real yields also matter a great deal for economic growth.<\/strong><\/p>\n\n\n\n<p class=\"wp-block-paragraph\">Because real yields are so important for borrowers and providers of capital and our economy functions smoothly when there is balance between the two, let\u2019s define a crucial macro concept:&nbsp;<strong>equilibrium real yields (r*).<\/strong><\/p>\n\n\n\n<p class=\"wp-block-paragraph\">R-star is the equilibrium real rate at which our economy functions smoothly and delivers its potential GDP growth without overheating or falling into a recession.<br>The younger, more productive and less indebted our economy is the higher r* is.<br>Unfortunately weaker demographics, stagnant productivity and a big burden of debt have lowered the equilibrium real rate at which our economies can smoothly function.<\/p>\n\n\n\n<p class=\"wp-block-paragraph\">Today, estimated r* is at 0.00% &#8211; 0.25% in the US and at -0.50% to -0.75% in Europe.<\/p>\n\n\n\n<p class=\"wp-block-paragraph\">R-star is a theoretical equilibrium real rate, but we can observe where real yields are actually trading in markets &#8211; and hence we can estimate whether&nbsp;<strong>markets are forcing the economy to work with real yields which are higher or lower than equilibrium.<\/strong><\/p>\n\n\n\n<figure class=\"wp-block-image size-large\"><img decoding=\"async\" width=\"1100\" height=\"655\" data-src=\"\/campus\/wp-content\/uploads\/sites\/2\/2023\/05\/d7d842e3-d2ac-41fa-ba7a-7175ebe52896_1302x775-1100x655.png\" alt=\"Real rates are way above equilibrium and likely to sit there until something breaks\" class=\"wp-image-190390 lazyload\" data-srcset=\"https:\/\/ibkrcampus.com\/campus\/wp-content\/uploads\/sites\/2\/2023\/05\/d7d842e3-d2ac-41fa-ba7a-7175ebe52896_1302x775-1100x655.png 1100w, https:\/\/ibkrcampus.com\/campus\/wp-content\/uploads\/sites\/2\/2023\/05\/d7d842e3-d2ac-41fa-ba7a-7175ebe52896_1302x775-700x417.png 700w, https:\/\/ibkrcampus.com\/campus\/wp-content\/uploads\/sites\/2\/2023\/05\/d7d842e3-d2ac-41fa-ba7a-7175ebe52896_1302x775-300x179.png 300w, https:\/\/ibkrcampus.com\/campus\/wp-content\/uploads\/sites\/2\/2023\/05\/d7d842e3-d2ac-41fa-ba7a-7175ebe52896_1302x775-768x457.png 768w, https:\/\/ibkrcampus.com\/campus\/wp-content\/uploads\/sites\/2\/2023\/05\/d7d842e3-d2ac-41fa-ba7a-7175ebe52896_1302x775.png 1302w\" data-sizes=\"(max-width: 1100px) 100vw, 1100px\" src=\"data:image\/svg+xml;base64,PHN2ZyB3aWR0aD0iMSIgaGVpZ2h0PSIxIiB4bWxucz0iaHR0cDovL3d3dy53My5vcmcvMjAwMC9zdmciPjwvc3ZnPg==\" style=\"--smush-placeholder-width: 1100px; aspect-ratio: 1100\/655;\" \/><\/figure>\n\n\n\n<p class=\"wp-block-paragraph\">The chart above shows a 20+ year history of US 5-year real yields minus equilibrium real rate r*: if the series records a negative level Fed policy was loose (real yields &lt; equilibrium) and if the series moves in positive territory the economy was forced to function with real yields &gt; equilibrium.<\/p>\n\n\n\n<p class=\"wp-block-paragraph\">Notice how&nbsp;<strong>every time real yields were sitting above equilibrium, something broke in the economy and in markets<\/strong>&nbsp;(2001 recession, 2008 GFC, 2018 stock market).<br>To the contrary, periods when real yields were below equilibrium were generally good for growth and markets (2004-2007, 2012-2017).<\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><strong>Real yields are the lubricant of our credit-based economic system<\/strong>, being the balancing mechanism that drives decisions for borrowers and providers of capital.<br>They are therefore also an important driver of investors\u2019 asset allocation preferences and economic growth.<\/p>\n\n\n\n<p class=\"wp-block-paragraph\">&#8212;<\/p>\n\n\n\n<p class=\"wp-block-paragraph\">Originally Posted May 14, 2023 &#8211; <a href=\"https:\/\/www.smartkarma.com\/insights\/the-real-deal\">The Real Deal<\/a><\/p>\n","protected":false},"excerpt":{"rendered":"<p>Our economic system is ultra-financialized and dependent on leverage. Real yields play a crucial role in that puzzle.<\/p>\n","protected":false},"author":1150,"featured_media":190392,"comment_status":"open","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"_acf_changed":false,"footnotes":"","jetpack_post_was_ever_published":false},"categories":[15,6,8,9,26,3],"tags":[1145,77,11840,15299],"contributors-categories":[13655],"class_list":["post-190389","post","type-post","status-publish","format-standard","has-post-thumbnail","category-fixed-income","category-north-america","category-region","category-securities","category-text-articles","category-traders-insight","tag-economics","tag-fed","tag-real-rates","tag-real-yield","contributors-categories-smartkarma"],"pp_statuses_selecting_workflow":false,"pp_workflow_action":"current","pp_status_selection":"publish","acf":[],"yoast_head":"<!-- This site is optimized with the Yoast SEO Premium plugin v26.9 (Yoast SEO v28.2) - https:\/\/yoast.com\/product\/yoast-seo-premium-wordpress\/ -->\n<title>The Real Deal | Traders&#039; Insight<\/title>\n<meta name=\"description\" content=\"Our economic system is ultra-financialized and dependent on leverage. 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