US Treasury ‘real yields’ about to eclipse inflation expectations

This is an audio transcript of the FT News Briefing podcast episode: US Treasury ‘real yields’ about to eclipse inflation expectations

Marc Filippino
Good morning from the Financial Times. Today is Tuesday, April 19th, and this is your FT News Briefing.

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We’re approaching a seminal moment in the world’s biggest government bond market. And US banks are seeing profit growth slow down, but Bank of America is surprisingly positive about the rest of 2022. Plus, Mexico’s populist president wanted a more state-controlled electricity sector, but its Congress said no thanks. We’ll talk to our correspondent in Mexico City. I’m Marc Filippino, and here’s the news you need to start your day.

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The Federal Reserve is raising rates and it’s causing real yields on US government to potentially turn positive. It’ll be the first time since March 2020. This would be a pretty big moment and could ripple into other US financial markets. To find out more, I’m joined by the FT’s US markets editor, Eric Platt. Hey, Eric.

Eric Platt
Hey, how’s it going?

Marc Filippino
It’s going all right. So Eric, what are real yields?

Eric Platt
Right, so the real yield is what you are being paid minus inflation. So when that number is negative, it actually means inflation is eating away at the returns that you’re getting paid. You’re actually losing money effectively. And so the Fed is, you know, is actively trying to tighten policy to cool both the economy and to really temp down these inflationary pressures that you’re seeing. And the way that filters through, right, is they raise interest rates. And as interest rates move higher, so do Treasury yields. And what you’re starting to see and what we could see very soon is, you know, the real yield on the 10-year Treasury, the benchmark for many, many contracts for countless parts of the financial system, could breach into positive territory. And this will have widescale ramifications.

Marc Filippino
So I want to get to those ramifications in just a little bit. But first, let’s just lay this all out here. So as yields go up, prices go down, they work in inverse, right? And this is to attract investors to buy yields, right? If prices are low and yields are high, it’s an incentive. But even with this happening, investors still aren’t buying. So have we gotten to a point where investors have just kind of given up on bonds?

Eric Platt
Well, really, one thing you have to think about is one of the biggest buyers of treasuries over, you know, since the start of the pandemic over the last two years has been the Federal Reserve. And their balance sheet has swelled to about $9tn. It’s really quite mammoth. They have such a large footprint in the Treasury market. And as they’ve stopped buying treasuries and as they’ve started to talk about actually letting them mature off their balance sheet, what that means is actually other investors have to fill that hole. And it’s a mammoth hole, right? They’re talking about rolling off tens of billions of dollars of treasuries a month starting later this year. And that means, right, your sovereign wealth investor in Japan, if your T Rowe Price, what have you, suddenly you’re filling this big gap and, you know, you don’t have unlimited firepower like the Fed. And so yield will start to rise, right? Because the buyer base is declining slightly, right? You’re demanding more compensation to lend to the US government.

Marc Filippino
So if real yields, you know, say they do break this into this positive territory or go even higher, we could see investor demand pop up, right?

Eric Platt
Exactly, and this is where you will see ramifications throughout other markets, right? When real yields were so depressed and so deeply negative, if you’re a pension manager, you’re like, oh, I’m gonna lose 1 per cent a year on this investment in US Treasuries. Maybe I’m gonna look into corporate bonds, or maybe I’m gonna look into loans, I’m gonna look at a wider array of options. Now as US Treasuries start to pay you a greater return, that calculus shifts a bit right? You’re suddenly like, oh, do I actually need to be going out on, consider it like the risk spectrum, do I need to be as risky as I’ve been? No, actually, you know, I can get 3 per cent a year on the 10-year Treasury. That’s not a terrible rate, perhaps, especially compared to, you know, recent memory.

Marc Filippino
And over the past few years, we’ve seen stocks soar, right? We were in a low risk environment. The stock market went up. And bonds, you know, people kind of forgot about bonds. But now that the stock market has gotten a little bit more volatile, could we see investors move towards something a little bit more low-risk, a little bit more secure, like bonds?

Eric Platt
Exactly, right. And this is actually like, we talked to investors and strategists, right? The $64,000 question is how high do real yields go, right? If the Fed is tightening policy, but actually treasuries kind of top out where we are. OK, is this super attractive? You know, maybe not. But every little bit counts and as it keeps rising, it will provide more income, more return for these investors, and it does start to weigh on demand and on other asset classes. And so this is what everyone is wondering just kind of how high can Treasury yields go?

Marc Filippino
Eric Platt is the FT’s US markets editor. Thanks, as always, Eric.

Eric Platt
Gladly.

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Marc Filippino
US banks had a tough first quarter as dealmaking slowed down and the war in Russia ramped up. The biggest US banks all reported slowing profits. And yesterday, Bank of America did the same. But as the FT’s Imani Moise reports, the country’s second-largest bank was notably optimistic.

Imani Moise
I think because what they’re seeing is the return of loan growth and loan growth is something that the industry has been waiting for for almost two years now, just after the stimulus and the tax credits and all of the kind of excess liquidity that consumers and companies had throughout the pandemic. There hasn’t been a lot of loan growth, which is kind of what a lot of the Main Street lenders like Bank of America, Wells Fargo, JPMorgan rely on to boost their revenue. So what they’re seeing is borrowing appetite return, and there’s the promise of higher interest rates from the Fed, all of which will mean higher revenue for these banks.

Marc Filippino
But Imani, there’s, you know, still concern over inflation, a possible recession as interest rates go up. Did Bank of America take all that into account?

Imani Moise
The term that they use is that they’re very mindful of these things. However, I think from their vantage point, they’re seeing a really, really strong US consumer. They’re seeing companies with strong balance sheets. So they believe that consumers can still withstand kind of the extra pain from inflation and kind of absorb some of that blow without necessarily plunging the economy into a recession. So, for example, Brian Moynihan, CEO of Bank of America, gave some colour on what’s happening with the lower income Americans and their lower segment of customers and saying they still have deposits that are significantly above pre-pandemic levels. So even if they have to spend more for fuel or spend more when they go shopping, they have enough cushion to kind of absorb that.

Marc Filippino
So why is Bank of America more bullish than other big banks?

Imani Moise
Yeah, I think the positive aspects of the report were able to shine through a little bit more just because they’re not as impacted by the war on Ukraine. They do have a more domestic focus than Citigroup, for example. So they didn’t have to worry about outsized losses tied to Russian exposure.

Marc Filippino
Imani Moise is the FT’s US banking correspondent.

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In Mexico yesterday, lawmakers rejected a proposal from the country’s populist president. It would have boosted state control of the electricity sector and weaken the role of private investors. It was a stinging defeat for President Andrés Manuel López Obrador or AMLO, as he’s known. Here’s the FT’s Christine Murray in Mexico City.

Christine Murray
It’s a stinging defeat because this is such an important issue for President López Obrador. But it wasn’t surprising in the sense that the markets were expecting this, given the makeup of Congress that López Obrador’s party, Morena, doesn’t have the supermajority that it needs in both houses to pass constitutional reforms.

Marc Filippino
Yeah, we should say that the energy bill that AMLO put forward, it did get a simple majority, not the two-thirds supermajority that it needed, but it did get a simple majority. Why didn’t the opposition get on board with the president’s plan?

Christine Murray
Well, there was a lot of strong opposition to this bill from the private sector, from diplomats and in particular from the US government, which was extremely worried by this proposal. They said they would use mechanisms under the trade agreement, USMCA. The private sector more broadly said that it would destroy investment confidence in the country and make Mexico’s electricity more dirty by relying on the state power provider rather than private renewables companies.

Marc Filippino
So Christine, is there a chance that AMLO could take another shot at this, or is this energy bill basically dead?

Christine Murray
So the president himself has said he won’t send another bill like this. And it’ll be up to whoever succeeds him in 2024, when there’s the next presidential election. And now everyone is paying attention to a bill to nationalise lithium that the president sent to Congress once it was clear that his constitutional reform in electricity was gonna be defeated.

Marc Filippino
Christine Murray is the FT’s Mexico and Central America correspondent.

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Finally, the Chinese government said the country’s economy grew 4.8 per cent last quarter. That’s faster than expected, but a closer look at the data shows consumer activity in the world’s second-largest economy is contracting. Chinese officials are enforcing Covid-19 lockdowns across the country, and that appears to be threatening economic growth. Retail sales, for example, fell three and a half per cent in March compared with the previous year.

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You can read more on all of these stories at FT.com. This has been your daily FT News Briefing. Make sure you check back tomorrow for the latest business news.

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