By Jamie McGeever

ORLANDO FL (Reuters] – Stocks face trouble when there is higher inflation, high interest rates and low bond yields. Wall Street has reached new heights due to the enduring phenomenon of subzero real yields.

Since the beginning of the year, there has been a significant improvement in the relationship between U.S. TreasuryInflation-Protected Securities’ “real” yields dropping to record lows while major U.S. Equity indexes have shot to new highs.

This has proven to be one of Wall Street’s few consistent factors as it has overcome many obstacles that might otherwise cause problems, including historically high inflation and inflation forecasts; Fed tapering and preparing for raising rates; spiked bond market volatility; and flattening or even inverted yield curves.

It is being questionned that long-held beliefs about these relations are changing.

While there may be bumps on the road, equity markets keep moving forward. Long-term bonds with low yields are less attractive than the discount rate, which is used to assess companies’ cash flows. Stock prices today reflect this. However, any support in the discount rates can redraw equity’s map along with the credit damage that comes from tightening.

Real yields could rise slightly as central bank tightening moves, but few people see them becoming positive over the long term. Gargi Chaudhuri (NYSE:), head of iShares’ investment strategy, says that we now live in a new environment in which old assumptions about rising interest rates or nominal bond yields being bad for equities must be challenged.

She says that real yields can become problematic if they move into restrictive territory, which is more important for equity. However, this will not happen in the next two- to three year.

Meghan Swiber is a rates strategist at Bank of America (NYSE.). She believes that 10-year real yields will remain low for approximately 10 years. Analysts Morgan Stanley The NYSE published an earlier version of a similar forecast in January.

FADE AWAY

Recently, inflation-adjusted TIPS yields have been diverging from those on traditional Treasury bonds. Both the ‘breakeven rate’ and closely watched measure of inflation expectations have risen dramatically.

Given the investor scramble for inflation protection, it is not surprising that real yields have fallen. The demand for TIPS (and related investments such as TIPS-exchange-traded funds) is high in fixed income.

U.S. 10-year yield was negative at -0.01% All year, the TIPS yield has been very negative. The TIPS yield has been in decline since the beginning of the year. It saw a noticeable rise after the last quarter. However, this week it fell to -1.24%. Although it remains low, the nominal 10-year yield is up 65 basis points.

Blackrock’s strategists, and Bank of America’s both claim that the demand for TIPS-ETFs is “incredible”, as it comes from investors who want to shorten their inflation risk and add inflation protection to their asset allocation plans.

Real rates remain negative and growth stays above trend. Consumer spending is stable, companies can pass higher costs on to customers. Equities may continue to perform fairly well to the extent that they are not.

In 2021, there were 65 new records set by the company. This is second in history and 12 behind the 1995 record of 77.

Third quarter earnings were solid: 80% of S&P 500 companies beat forecasts, with that rising to 93% for the tech sector. Although valuations are still very high, they don’t seem prohibitive.

If the Fed fails to convince investors, and perhaps even itself, that the taper period is finished around the middle year next year, then rates could be set back.

TIPS can be expensive. Are real yields possible to go negative? Perhaps, if Britain serves as a guide. Inflation-linked gilt yields below 3.0% for 10 years and have been at sub-zero levels for over a decade.

Capital Economics’ markets economist Oliver Allen believes that Wall Street’s influence on real yields will slowly fade, as higher inflation forces the Fed into tightening policy.

Allen said that “the tailwind of falling real returns turning into a modest heading is why we believe U.S. Equities will struggle to achieve gains over the next two years.”

(By Jamie McGeever)