The real impact of the real yield
The real yield dictates the real cost of borrowing, and therefore the real return on savings. Market rates tend to track the official cash rates set by central banks, at least in the short-to-medium term. When official rates are greater than the rate of inflation, savers can invest in cash deposits and risk-free government bonds and earn a return in excess of inflation. When this is the case, the real interest rate is positive. The magnitude of the real rate represents the time value of money. Positive real rates encourage saving.
Negative real rates occur when the official cash rate is less than the rate of inflation. The value of lazy cash in savings accounts is eroded by inflation. It follows, negative real rates encourage spending, and investing in real assets whose returns are correlated with inflation such as real estate, commodities, and to a large degree, stocks (assuming companies have the ability to increase their prices).
Right now, real interest rates are positive and rising. As the US Federal Reserve has aggressively increased its official cash rate, and more recently as core inflation has receded, it has created an environment of positive real yields. This is posing a challenging environment for stocks, as capital is directed towards higher yielding, lower risk investments such as long-term US bonds. It also encourages households to favor savings over consumption and this has potentially equally dire consequences for stocks.
None of this is particularly surprising to the Fed. This is all part of their plan in fighting inflation. They would argue that they've come a long way in that fight and that a contraction in spending and investment in risky assets is part and parcel of the adjustment process. You must break a few eggs (stocks, the economy?) to make a low inflation omelet!
Lower yielding, longer duration stocks tend to be hit the hardest during periods of high and rising real yields (i.e., stocks whose businesses are largely backed by debt in their early growth stages and for which earnings are still in the future). The Nasdaq Composite Index contains a larger proportion of longer duration stocks than the other major indices. We should not be surprised then that it has suffered the most in the recent downturn.
And then there's China...
Add in the stock market's woes is the worsening economic picture in China. This week we saw sharply weaker data on industrial production, retail sales, and employment. The National Bureau of Statistics (China) even announced that it intends to suspend the release of youth unemployment data. Not a good look.
As the broader economy weakens, putting Beijing's 5% p.a. GDP target further out of reach, the property sector appears to lurch from bad to worse. The once-biggest property developer Country Garden this week suspended trading in several of its bonds as it has tripped the deadline for interest payments. Finally, data showed home prices in China's second-tier cities continued their downward spiral in July, while major city prices were at best, flat.
Stocks are stuck between the proverbial rock of rising real yields, and the hard place of the ailing Chinese economy. Investors hate uncertainty, and they're receiving extra helpings this week. In today's Live Market Analysis – Macro Edition I investigate the major macroeconomic challenges facing stocks, bonds, commodities, forex, and cryptocurrencies with in-depth technical and fundamental analysis. Hit play on the video below to view.