Things Just Got ‘Real’

An increasingly acute tightening impulse from a buoyant dollar and surging US real yields is turning the screws on risk assets.

The move crescendoed midway through this week, when five-year reals exceeded highs seen in June to reach levels not witnessed since 2019.

Falling commodity prices weighed on near-term inflation expectations, exacerbating the move, which was particularly acute in the two-year sector. This conjuncture is both a cause and a consequence of the stronger dollar.

Five-year reals rose 35bps in the handful of sessions since Jerome Powell’s Jackson Hole speech (figure above). They’re up some 80bps since slipping back into negative territory following the July FOMC meeting.

From the lows on July 29, two-year reals rose more than 145bps through Thursday morning. August’s rise was the largest monthly increase since the financial crisis. The nominal two-year yield reached 3.5% for the first time since 2007 this week. Two-year breakevens fell 75bps over the same period.

The figure (below) shows successive tightening shocks in 2022. Note that short-dated reals peaked at 2% during the Fed’s last tightening cycle. Another month like August and we’ll be back near those levels, likely to the detriment of equities.

Again, this a very acute tightening impulse. If the Fed does manage to achieve 4% and clings to terminal for any appreciable length of time, it’ll likely get more onerous.

“Now that the ECB has been forced to further escalate their hawkishness after a series of ongoing hot inflation prints beyond just energy inputs, terminal rates on both sides of the Atlantic [are] grind[ing] higher, while simultaneously being pushed further out as well,” Nomura’s Charlie McElligott said Thursday. “After all, it’s ‘higher / more restrictive for longer’.”

Indeed it is. Naturally, this is feeding dollar strength, which in turn pressures commodities (the Bloomberg Commodities gauge is down 4% this week), pushing breakevens lower and mechanically nudging reals higher still.

I should note that a flatter real yield curve could eventually be self-defeating for the dollar, but that’s not this week’s story. For now, it’s a straightforward tale. As McElligott put it, “‘impulse tightening’ in US financial conditions is causing further breakage, most notably evidenced by the prolific move in short-dated US real yields to multi-year highs, corresponding, of course, with cratering crude oil as the ‘inflation’ input, but also with broad risk assets losing the plot.”

The Bloomberg dollar index hit a record high on Thursday. The yen dropped to 140 for the first time since 1998.