Photo: iStock
Photo: iStock

Expected Federal Reserve tightening is of course the main reason for rising real yields, but there is a noteworthy risk component as well. TIPS (Treasury Inflation Protected Securities) are the ultimate safe harbor in crisis, and TIPS prices over the long term trade in parallel with other safe harbor assets, for example gold or the Japanese yen. In the case of a catastrophic decline in the dollar and subsequent inflation, TIPS will pay a yield adjusted for the inflation rate. In deflation, TIPS will still pay a positive yield.

That observation has considerable importance for equity markets. A number of brokerage house strategists have issued warnings that a rise in real yields threatens the equity market. That might be true if the rise in yields occurred due to aggressive tightening by the Fed. But part of the rise in yields clearly reflects a diminished market perception of systemic risk, which reduces the value of TIPS as a risk hedge. In that case, dampened risk perceptions would be a plus for the equity market rather than a negative.

The inverse relationship between the gold price and the 10-year TIPS yield remain consistent and visually obvious during the past year and a half:

TIPS yields follow a rising trend (defined by the expected future trajectory of Federal Reserve policy), but within that trend, an inverse relationship is quite clear. TIPS yields rise when TIPS prices fall, so a higher yield means that TIPS are less valuable. During the past month, TIPS yields rose as the gold price fell. That probably reflects reduced risk perceptions on the Korean peninsula and perhaps in the Middle East.

We can measure the effect of gold on TIPS yields by regressing TIPS yields against the expected future federal funds rate a year hence (the 12th fed funds future) with and without the gold price. The result is shown below:

The TIPS yield has risen faster than the fed funds future would indicate during the past couple of weeks, but most of that increase is explained by the fall in the gold price.

From this we may conclude that a gradual and measured increase in US interest rates will not be as disruptive for equity markets as some market strategists believe.