Higher real yields and the reaction function of central banks

Earlier this year, the oil shock from the Iran War generated energy inflation that eventually morphed into broader, more persistent price pressures. We have now entered a phase of more persistent inflation, shifting the debate towards the reaction function of central banks.

The bad news is that we do not fully understand this reaction function anymore. The new Federal Reserve (Fed) leadership appears intent on changing the rules of the central banking game. At the same time, a broad range of signals points to higher real yields and potentially more volatile real yields. This is a material source of risk for global portfolios and will likely be one of the key variables to monitor in Q3.

The key questions are: why are real yields high? Is this a dangerous development? And should we expect real yields to fall back? The short answer to this final question is ‘no’. The longer answer, Simply put, is below.

Expansion, not stagflation

The first message our macro indicators are feeding into our investment decision dashboard is the following: despite the oil shock, the global economy is not experiencing stagflation.

When oil prices moved sharply higher, investors naturally prepared for a stagflation shock: higher energy prices would weigh on demand while adding to inflation, challenging the Goldilocks narrative that had framed the start of the year. But so far, the global economy has proved far more resilient than expected. One important reason is that the much-discussed AI-related capex cycle is acting as a genuine source of growth – first for the US economy, and increasingly for the rest of the world as well.

The phase diagrams in Figure 1 track the joint evolution of diffusion indices for growth and inflation in the US and the global economy since 2022. The message is clear. Initially, the period of elevated policy rates did cause some deterioration in both growth and inflation, pushing both economies into the slowdown quadrant. But that phase has proven short-lived. A brief flirtation with stagflation followed, before moderating inflation allowed central banks to begin cutting rates, which in turn supported a recovery in global activity.

Read also: Multi asset: what if real yields settle higher?

Interestingly, the impact of trade tariffs is barely visible in the data and, if anything, appears associated with a mild decline in inflationary pressure rather than an acceleration. Most importantly, the latest observations – corresponding to the past 12 months – suggest that the world economy has now entered another phase of expansion. This is not stagflation, despite what many observers expected. It is expansion – and that has direct implications for real yields.

FIG 1. Nowcaster-based world investment clock¹

Expansion means high real yields

Using the same quadrant framework, the next question is: does expansion naturally come with higher real yields? Figure 2 examines historical levels of real yields across macro regimes, using trailing inflation to enable a comparison with the 1990s. The analysis is conducted for the US and the global economy.

The conclusion is straightforward. Historically, stagflation is associated with the highest real yields – both in the US and globally – which fits the intuition that stagflation eventually forces monetary policy to respond more aggressively to inflation pressure. But expansion also tends to be associated with real yields that are above their long-term average. In other words, even outside a stagflationary regime, stronger growth and firmer capital demand support a higher real cost of capital.

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

That conclusion holds for both US and world data. Looking at today’s real yields, the global level appears broadly consistent with that expected in an expansion regime. The US, however, stands roughly 30 basis points above that benchmark. Those extra 30 bps probably reflect the current wave of capex, which is adding to the ongoing recovery and reinforcing demand for capital.

FIG 2. Real yields level per investment clock quadrant²

The broader message of the chart is important: unless one expects some form of meaningful slowdown, the current level of the cost of capital is likely to persist. Moreover, a European capex wave could push global real yields somewhat higher. Put differently, when thinking about real yields through a cycle lens, the bias should not be to look down.

There is, however, one force that could push yields even higher: the emergence of a genuine stagflation regime. That is not our core scenario. But it would not take much – a few additional rate hikes, or a stronger second-round inflation effect – to move in that direction. Monetary policy could therefore be a wild card for the second half of the year.

How hawkish could central banks be?

Monetary policy currently poses two challenges.

The first is that we still do not know how persistent inflation pressure will be. Recent US inflation data continues to show some stickiness, particularly in services. European inflation moderated in June, but the region is not fully out of the woods given the magnitude of the oil shock. Uncertainty will shape how central banks initially react to what still looks, for now, like a moderate energy shock.

The second challenge is that in an expanding economy, energy inflation could easily spill over into broader inflation. Gauging those second-round effects is always difficult, especially when growth remains firm.

And then there is the Fed. Kevin Warsh is the new sheriff in town, and his intellectual reference point appears to be closer to Alan Greenspan than to the more recent era of forward guidance and balance-sheet management. How significant could that shift be? In our view, potentially very significant.

Central bank response

Figure 3 helps frame the issue by showing the historical beta of central bank policy rates to inflation, across governors of four major central banks. The picture is clear: since the Greenspan era, central banks have not needed to react forcefully to inflation to preserve credibility. Globalisation helped deliver goods disinflation, and central bank credibility did the rest. But that environment may be fading. A more regionalised world could bring structurally firmer goods inflation, while the abandonment of forward guidance increases uncertainty around the policy path. Add the fact that inflation in the US has remained above the Fed’s target since February 2021 and suddenly the central banking world appears far more uncertain.

That uncertainty matters because it should eventually feed into the term premium, itself an important component of real yields. In other words, even if inflation does not spiral higher, uncertainty about how central banks respond may still keep real yields elevated.

FIG 3. Historical beta of central-bank rates to inflation by governor showing the sensitivity of central banks to inflation³

Read more: Multi asset: navigating an inflation shock

The role of real yields in the long term

From a longer-term perspective, this potentially new macro-financial environment may not simply be a temporary episode and is likely to differ from the one that shaped the previous decade. One of the defining characteristics of this forthcoming environment could well be structurally higher real yields. This provides an opportunity to rethink the role of real yields in asset allocation over a multi-year horizon. Two forces, both illustrated in Figure 4, stand out.

The first is the Fed’s balance sheet. If the new Fed leadership is less supportive of quantitative easing-like policies, quantitative tightening could continue further than markets have grown accustomed to. The left side of  Figure 4 shows that over the past 30 years, real rates have been negatively correlated with the Fed’s balance sheet. US rates remain the anchor for most global curves, so a smaller Fed balance sheet mechanically argues for a larger real rate premium. If the balance sheet were to fall toward 10% of US GDP, the upward pressure on real yields could intensify.

The second force is demographic. Demand for capital is currently strong, driven by the capex cycle and expanding government borrowing needs. But at the same time, the global supply of savings is no longer rising the way it once did. High savings rates are more a feature of younger economies; ageing societies tend to run them down, particularly in regions where inflation has eroded household purchasing power. The result is simple: a lower savings level, all else equal, means a higher cost of capital.

This matters because it implies that high real yields may be a key theme for the coming years.

FIG 4. Real yields as a function of central bank balance sheet and available savings⁴

Simply put, the combination of ongoing expansion, central bank uncertainty and longer-term structural forces points to one conclusion: real yields are likely to remain high and could move even higher.