The Daily Update - The Real Yield Trap

The real yield of investments is not so important over a shorter time horizon, however, the devaluation of the particular investment due to inflation, over time, really needs to be noted; historically it remains a good measure of value.

When you get to extremes and prolonged periods of fabricated adjustment - central banks call it the monetary tool box, the kick-back from the adjustment, the bounce back - the correction of the level of rates could be extreme.

The euro curve at 5-years maturity offers a real yield of -2.23%, 10-years is slightly better off at -1.60%. The latest euro reading, on the average was released at 2%, as expected by the market. However, German and French inflation is higher year-on-year at 2.3% and they are the largest economies in the eurozone. The ECB needs to take note, a credibility gap could evolve.

When the 10-year Bund moves from a yield of 0.40% to 0.70% that will give bond holders a loss of 3 points in price. To get back to flat to inflation, i.e. have a flat real yield curve, where your investment is not eroding over time, the 10-year Bund price needs to fall 14.5 points in price and short rates need to move up 260bps.

We think this will become an issue soon; the first sign was European investors moving back from US dollars as the hedge cost was so high, which is a short term strategy, and rather short sighted, unless you’re a dealer/hedge fund trading with a 2 day horizon.

European investors appear to have moved back into the euro yield curve on mass. This is entirely due to the EUR/USD hedge cost. With the hedge cost approximately around 2.5% per annum at the moment that is their focus, this is short-term the spread is due to tighten, however, the hedge cost is cheap compared to a few days move in bond rates. Only a small equivalent move in bond yields could wipe out the cost of being in the US curve, which is priced accordingly to the current situation and with a real yield across the entire curve, could be cheap compared to investment in the European curve of just about any maturity.

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