Real Yields are a Real Problem

Let's get ready for the Oct release of US CPI along with jobless claims (out 1 day earlier than usual due to Veterans Day tomorrow). One of the great puzzles in markets at the moment is the ongoing drop in inflation-adjusted bond yields and how it points to trouble ahead. The trade has the potential to blow up and reverberate through markets. US CPI is due up next (more on it below). On Tuesday, the WhatsApp Broadcast Group had a few "quick" daytrading trades in XAUUSD (long at 1821 for 1830), DOW30 (long/short inside 36170/230) and DAX40 (15990-16050). 

The yen was the top performer on Monday while the Australian dollar lagged. The theme in the FX market continues to be yield-spread compression as central banks push back on inflationary concerns.

What's concerning is that US real yields in 10s and 30s are at all-time lows. In 30s, TIPS hit a record low of 0.578% on Tuesday while nominals trade at 1.82%. That difference reflect average inflation of 2.4% over that timeline and signals that owning either asset will result in a substantially negative real return.

It also makes a compelling argument that the bond market is the greatest bubble in human history with $22.1 trillion in Treasuries outstanding and an order of magnitude globally priced against it.

Should inflation normalize at 2.4% it should prompt a Fed normalization over time, crunching long-dated bonds and quickly threatening to invert the yield curve. That's something that would imply lower inflation and boost real yields. Alternatively, long-end nominal rates could push higher on sustained high inflation and crush outright bond longs.

That's something to ponder over the longer term but in the days ahead, volatility in the bond market remains elevated and that's something that could spill over. The calm and enthusiasm in the equity market is masking deep issues in bonds. As usual, bonds will win out.

A potential breaking point is only hours ahead with October CPI due at 1330 GMT. There were no clues in Tuesday's PPI report, which was largely in line. The CPI data is expected up 5.3% y/y, a slowing from 5.4% in September. Core m/m inflation is expected at 0.3%.