Multi asset: what if real yields settle higher?

Today's market environment is prompting investors to rethink portfolio construction and challenge long-held assumptions. It also invites a look back at history to assess how different today really is. 

In our view, the key issue is interest rates. While we focused on rates volatility in the past, we now believe the level of rates itself is the critical variable. The QE era is firmly behind us, and the normalisation of the bond-equity correlation has reduced diversification, and increased carry, bond risk and discount-rate risk.

The following is an excerpt from the latest quarterly edition of Simply put, which returns to the fundamentals of long-term yields to explore key questions. At its core, it examines what drives rates and how they influence the economy and markets.

The Greenspan conundrum revisited

Understanding interest rates means understanding the forces shaping the yield curve. Two-year and 10-year yields sometimes move in lockstep, and at other times they diverge. Why does their interaction matter now? Because of AI. The scale of today’s capex cycle and industrial transformation create a backdrop reminiscent of the past – notably the period when the late Alan Greenspan questioned the behaviour of long-term yields. After the tech bubble burst, but while telecom investments were continuing across the US, Greenspan repeatedly pointed to the limited reaction of 10-year yields to the Federal Reserve’s interest rate cuts.

Figure 1 explores this pattern and suggests that this question could have been raised in later periods as well. While the correlation between 2-year and 10-year yields declined between 1995 and 2005, especially relative to the Volcker era, it fell to much lower levels during the QE period. The key point: even though this correlation has largely normalised today and returned to pre-QE average levels, it continues to be an unstable relationship. And if the 1995-2005 period is any guide, that correlation has room to be revisited by markets. 

Understanding this phenomenon involves investigating the respective fundamentals of 2-year and 10-year yields.

FIG 1. 2Y vs 10Y yields - rolling correlation (US)¹

Read also: Why are long-term bond yields rising?

Where the 2s and 10s diverge 

To understand what drives short- and long-term interest rates, it helps to examine the factors that have influenced them over time. Three stand out as particularly important today:

• The first is monetary policy, of course. The new Fed chair, Kevin Warsh, appears more determined than his predecessor to bring US inflation back to target, suggesting that monetary policy could remain a key factor for the bond market in the coming quarters
   
• Second, public spending is known to affect the price of money through the crowding-out effect, as raising capital in markets can constrain the private sector by pushing rates higher, another topic at the forefront today
   
• Finally, investment. Surging capex increases demand for capital, thus raising the cost of capital.
   

Read more: Multi asset: navigating an inflation shock

At this point, it is important to distinguish between real rates and inflation compensation, as captured by inflation breakevens, since they do not necessarily react in the same way to these factors.

Figure 2 displays the diversity of rate components with respect to each of these three factors by contrasting the behaviour of inflation breakevens and real rates. Our observation is striking: correlations for the 2- and 10-year segments to these factors appear relatively steady across the curve, but it is not the case for real yields. The chart shows that short-term real yields are less reactive to central bank rates than longer-term yields. 

It also highlights how the sensitivity of the 2-year yield to public debt is much lower than that of the 10-year, which intuitively suggests that it is a long-term worry rather than an immediate concern. At the same time, investment exerts upward pressure on real rates across both short and long maturities, marginally more on the short-term. 

Taken together, these elements suggest that monetary policy, public debt and capex dynamics all have the potential to push yields higher, raising a broader question: what is the overall impact of these forces, and what should investors do?

FIG 2. Correlation of 2- and 10-year yields in the US to their fundamentals²

Rethink diversification?

US 10-year real yields have now risen above 2%, while in the eurozone they have crossed the 1% threshold – a configuration not seen for decades and one that underscores the scale of the changes underway.

A combination of persistent inflation, rising public debt and surging investment demand is pushing real yields higher. The growing use of debt financing by AI companies reinforces this trend and prompts a reassessment of asset-class sensitivities to higher real-rate environments.

Figure 3 points to a simple but important lesson: periods of negative real yields and periods of high, positive real yields tend to favour different investment strategies. While negative real yields are generally supportive of equities and commodities, higher real yields make bonds more attractive by boosting carry, while creating a more challenging environment for equities and commodities. Traditional asset classes can still perform, but all remain sensitive to real yields, with equities typically the most affected.

The key message from the chart, in our view, is that investors should rethink their exposure to liquid alternatives, since hedge fund index returns have historically behaved well in those ‘extreme’ scenarios. High real yields are not necessarily bad for the investment environment because they also provide carry, but through a higher cost of funding, they can eventually put pressure on cyclical assets. In this context, diversification remains one of the most compelling responses. Liquid alternatives require further analysis, as hedge fund indices are far from a homogenous asset class – a point we explore in Section 4 of Q3 Simply put.

FIG 3. Sharpe ratios per asset class as a function of real yields in the US ³

The broader conclusion is that higher real yields should encourage us to maintain some exposure to yield as a source of performance, but also to seek assets that are less exposed to duration, with equities appearing eventually as the weakest link in the real-yields chain.

Simply put, changing times call for a rethink of where diversification comes from. Liquid alternatives stand out as a potentially attractive source of returns if real yields settle at higher levels.