Normalization is Soaring Real Yields

Interest rate normalization isn't the end of the world. It's the end of the stock and bond market bulls.

What would a successful exit from QE look like for the Federal Reserve? High time preference "investors" will say it includes things like the stock market not collapsing 50 percent. Low time preference investors are agnostic about how we get there, than what it looks like once we're there. If you know what a normal bond market looks like, you can extrapolate back to the present. Then determine what is cheap or expensive.

A normal bond market has much higher interest rates for any given level of inflation. Even if inflation settles back to around 2 percent per annum, the 10-year bond yield should have a low of around 3 percent and probably trade more in the area of 5 percent. A normal market has significant positive yields. Retired people can put their money in a CD at the bank and preserve purchasing power, while also making a little income.

What does that look like in the market? One sign is a collapse in the price of inflation-protected bonds because interest rates are positive. Inflation-protected bonds pay interest plus inflation. If inflation is expected to be higher than interest rates, investors pay a premium to own them. If inflation is 5 percent and interest rates are 1 percent, investors might bid the inflation-protected bonds up to negative 4 percent interest, since at that point, the bonds would have the same return as a regular bond paying 1 percent interest. Markets are dynamic, but that's the logic. As you can see from that example, if rates go higher or inflation comes down, inflation-protected bonds could rapidly tumble in price. Before the financial crisis in 2008, the 10-year inflation-protected bond had a positive yield that averaged 2 percent in the 2000s. 

The three charts below are the treasury inflation-protected ETF (TIP) without dividends, the market yield on inflation-protected 10-year treasury bonds and finally the chart of TIP including dividends.

Inflation-protected bonds have completely reversed their rise since the 2020 pandemic. The bubble is over, but the stock market doesn't really believe it yet. Prepare accordingly.

As for where rates will go, this chart tells me the market will take real interest rates positive if inflation stays high. What I do not know is inflation. If you think you know where inflation will go, then add a positive number to that to get the 10-year yield.

Below is the 10-year inflation breakeven rate. The market is pricing securities such that if inflation averages 2.87 percent over the next decade, an investor should be indifferent to holding a 10-year treasury and a 10-year inflation-protected security. This tells us the 10-year yield would be around 6 percent today if the bond market was normal.

I can see both side of the argument and I'm not confident which way inflation will go. Short-term, I see it coming down with QT. The Fed could panic again, cut rates and do a new round of QE. Or QT could continue until the bond market is normalized. 

The two biggest (related) misconceptions in the market today is that the Federal Reserve will not crush the stock market and that the economy will collapse at higher bond yields. There's always going to be a painful transition, but if the economy can handle 5 percent interest with the CPI at maybe 3 percent long-term, then it can also handle a bear market in stocks. Normalizing the market requires a bear market in both stocks and bonds at some point in the process.