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The biggest change on the margin in the financial markets continues to be the rise in real yields, so this update to my earlier article is both timely and important. Higher real yields reflect not only an improving outlook for growth but also a decline in inflation expectations, and that is a sanguine combination.

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Real yields on five-year TIPS (see chart above) have soared almost 110 bps since the end of March, to their highest level in more than 18 months.

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Ditto for real yields on 10-year TIPS, which are up 100 bps from their December lows.

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As the chart above shows, both real and nominal yields are up on the margin, but real yields have increased by more than nominal yields, thus reflecting a moderate decline in inflation expectations. Inflation expectations are still within a "normal" range, however, and do not reflect any serious risk of deflation.

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As I've argued before, government-guaranteed real yields that are available for purchase in the TIPS market can tell us a lot about the market's expectations for real economic growth. As the chart above suggests, the negative real yields on TIPS that we saw earlier this likely reflected market fears of very slow GDP growth. Investors were willing to lock in a negative real yield on TIPS because they feared that the real yields on alternative investments would be even worse, the by-product of collapsing real growth. Real yields are now moving back up toward levels that are more consistent with economic growth of 1%-2% per year in the years to come. So this is not a market that has suddenly become optimistic; it is a market that has become less pessimistic. That's not unreasonable at all, given the modest to moderate growth signals we see from other indicators.

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The recent decline in the price of gold is also consistent with the message of TIPS. Gold had reached exceptionally high levels not too long ago, arguably driven by fears that the Fed's QE policy might lead to a serious increase in inflation, as well as by fears that the economic outlook was fraught with risk stemming from huge increases in government debt in most developed economies. We now see that the U.S. federal deficit has declined significantly, and TIPS are telling us that inflation risk has also declined, and that the Fed is now likely to reverse QE sooner than expected, thus reducing the likelihood of failure. As I've suggested in a prior post, it looks like gold prices are now coming back down to a level more consistent with other commodity prices. That spot commodity prices are still quite elevated relative to where they've been in the past few decades arguably confirms that the outlook for global growth is far from precarious, so there is no sign here that a Fed reversal of QE poses any serious threat to growth.

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As the above chart shows, every recession in the past 50 has been preceded by a significant rise in real yields (the result of concerted Fed tightening), but the current rise in real yields still leaves real yields at very low levels. A true Fed tightening involves not only very high real yields (on the order of 4% or more), but also an inversion of the yield curve. Neither of those conditions exist today. The yield curve is still quite steep, and that implies that monetary policy is still expected to be accommodative for the next several years at least.

The recent jump in nominal and real yields does not threaten the health of the economy. Rather, higher yields reflect a market that is adopting a healthier expectation for growth in coming years. Higher rates normally accompany a healthier economy; they only rarely weaken an economy. This is all very good news.

Source: Soaring Real Yields Are Good News