Rates: Real rates begin to diverge

Something important happened this week. The US 10yr real yield finally broke decisively into positive territory. The move looks and feels like a confident one, one that is signalling an end to negative real rates, and a move to sustained positive real (10yr) rates.

But higher real rates also represent a tightening in financial conditions. This is the classic conundrum of the economic cycle where big swings in positive momentum are often precursors to more troubling times ahead where real rates are forced lower as excess consumption morphs into higher savings. But that’s for later.

For now, the firming path is correlating with tighter financial conditions. The bulk of this so far has come from higher market rates feeding into wider retail and wholesale rates. As the Federal Reserve hikes rates, they are simply ratifying a path already being mapped out by the marketplace, bolstering the tighter circumstances.

And in the eurozone, although the ECB has not even touched its rate hike trigger, financial conditions here have been perceptibly tightened too. Wider credit spreads, the likes of Italian yields under extra rising pressure, and large implied rate hikes discounted in market levels area are all contributing.

The 10yr real rate in, say, Germany is -1.8%. Deeply negative still. At the same time, 10yr eurozone inflation expectations are quite similar to US ones, in the 3% area. Long term inflation is elevated in both centres, but real rates remain down in the dumps in the eurozone. In contrast, real US rates have spiked.