One week / one topic: Staying real or staying loyal?

What happened?

The seemingly relentless march higher in US yields is asking investors the same question more and more loudly: are you sure?

While there aren’t (yet?) feasible alternatives when it comes to sourcing portfolio insurance – most developed markets (DM) yields move largely in sympathy with US Treasuries (USTs), and the gold market is tiny in comparison – there is currently no shortage of fiscal and policy concerns about the US.

Following the recent US credit downgrade from Moody’s and the passage of the tax bill in the House – correlation is not causation, but still – US 10yr and 30yr yields have now reached critical levels where the bond market is increasingly calling the bluff of US policymakers.

‘Nice $29tn pile of Treasuries you have there, bro… It’d be a shame if something happened to it. Plus, how much more debt did you say you want to sell this year?’

And yet, what also stands out is that recent moves have mostly comprised of an increase in real yields, which have now reached 10yr highs at the long end of the curve not only in the US but in Germany and the UK as well.

As a reminder, real yield = nominal yield – inflation expectations, which implicitly means that the market’s traded measures of inflation expectations (breakevens) have remained relatively anchored.

While this is in contrast with many recent surveys, we’d give priority to traded measures – where investors are expressing views by putting money on the table – as opposed to inevitably flawed questionnaires where political bias seems rampant.

Putting it all together, is it time to buy inflation-linked bonds then?

Our observations

• Fundamentals: While the vagaries of inflation sit firmly in the camp of things that are impossible to know in advance, there seems to be a meaningful margin of safety available here, hopefully compensating you for the uncertainty.

• Price action: Even following ‘sensible’ jumps around fiscal and tariff announcements, real yields keep travelling higher across all three countries. A risk or an opportunity?

• Investor beliefs: The post-GFC and monetary policy regime seems to be definitively dead and buried by now – MMT*, anyone? – but perhaps the moves in linkers are overdone at this stage?.

* Modern Monetary Theory (MMT) is a macroeconomic theory postulating that sovereign currency-issuing governments can spend freely to achieve full employment, limited only by inflation.

So what?

Considering a partial switch out of long-dated DM govies positions and into linkers inevitably presents challenges that merit careful consideration.

On one hand, the ‘line in the sand’ assumption is being tested in real time and therefore we still think there is a meaningful, attractive asymmetry to long-dated UST positions.

We are at 4.53% and 5.03% on the 10y and 30y respectively, so very much in the territory where the assumption about 4.5% and 5% key levels would be tested – but still close enough that the jury is out.

Also, after wearing the position until now, the endowment effect is a real risk here.

At the same time, a (partial) switch into linkers would add portfolio insurance vs stagflationary outcomes similar to 2022, the likelihood of which we consider to be increasing at the margin.

By implementing such a move, we would essentially be trading convexity risk for inflation risk: nominal bonds remain powerful tail-risk hedges in deflationary growth shocks à la GFC, but linkers would add inflation protection as well.

All in all, the prospect of the highest inflation-hedged, risk-free returns available over the last decade is hard to pass on – but the timing of any moves is crucial, especially in light of the unforeseeable, sudden news developments that have now become commonplace in the world of Trump 2.0.

Mood music: Jessie J – Price Tag