Reaching the point of no (real) return

Peter Warburton/Tom Traill - 30 January 2020

In the days before large-scale QE, bank deposits bore positive real returns in most advanced economies. Typically, benchmark government bond yields offered even higher real and nominal returns than bank deposits. Savers, large and small, enjoyed access to capital-safe investments in ‘hard’ currencies which would accumulate over time to build real wealth. In the post-apocalyptic landscape of 2020, the real yield on advanced economy deposits is zero at best and few governments in the developed world offer positive real bond yields. This blog explores just how scarce real yields, in respected sovereign debt markets, have become.   

For those who view the world through a deflationist lens, it is just possible to comprehend the current paucity of bond market yield. Investors who think that inflation is anchored close to zero can justify buying a 10-year bond on only 1.5 per cent yield, for example, supposing that this will allow scope for a positive real return. However, at prevailing CPI inflation rates there are very few local real yields available. As shown in figure 1, below, of the 38 countries in our sample 24 have a negative real yield: the nominal yield is lower than the three-month average of domestic CPI inflation. Dutch investors receive a real yield of minus 2.9 per cent on a 10-year bond, whereas at the other end of the scale, in South Africa there is still a 4.7 per cent real yield by this measure.

It is telling that a late-year burst of inflation – notably in China and India, but also in US and Eurozone – has made no impression on government bond pricing, meaning that real bond yields have fallen further. By our calculations, global CPI inflation (figure 2) has climbed to 3.2 per cent and has traced out a shallow rising trend for the past five years. In a world where central banks are contemplating additional rate cuts, rather than hikes, the outlook for real rates is grim.
Eleven nations sport real benchmark bond yields of 100 basis points or above: South Africa, Mexico, Philippines, Russia, Malaysia, Colombia, Korea, Thailand, Singapore, Italy and Greece. From the standpoint of North American or Western European investors, some allowance for prospective changes in currency valuation is required. A 5 per cent real yield in terms of local inflation looks attractive, but if the local currency has a habit of depreciating by 10 per cent per annum, then the true return to the foreign investor is minus 5 per cent. 

The cone in figure 3 is bounded by two diametrically opposite views about currencies. The pale blue diagonal marks the boundary of a positive real, currency-adjusted return based on an extrapolative view of currencies: this takes the appreciation/depreciation against the US Dollar in the past year as the best guide to the future. The pink diagonal marks the boundary of a positive real return based on a random-walk view of currencies, where last year’s exchange rate movement (in either direction) is expected to be reversed in the current year. 

The most robust bond markets offer the expectation of a positive real return under either interpretation of currency movements. The four markets left standing are Colombia, Mexico, South Africa and Malaysia, but of these only Malaysia has respectable statecraft credentials.  The Heritage Foundation’s 2019 Economic Freedom Index ranks Malaysia 22 in the world, against Colombia 49, Mexico 66 and South Africa, 102. On the sub-index for government integrity, Malaysia ranks 32, followed by South Africa 71, Colombia 109 and Mexico 141.

Little wonder that international investors dabble in emerging sovereign debt and sub-investment grade US and European corporate debt markets when deprived of the capital-safe real yield in top-ranked sovereigns.  

Figure 1: 

Data source: Thomson Reuters Datastream and Economic Perspectives calculations

Figure 2: 

Data source: Thomson Reuters Datastream and Economic Perspectives calculations

Figure 3: 

Data source: Thomson Reuters Datastream and Economic Perspectives calculations

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