Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 406

Real yields, inflation and risk assets in a transition

The fixed income world is beginning to undergo a multiyear transition as monetary accommodation and government spending across key economies drive higher near-term economic growth rates. The result could be a shift to higher real rates as output gaps narrow, as well as moderately higher but stable inflation.

In our opinion, this bodes well for risky assets, but will likely be accompanied by increased volatility and changing correlations.

Investment implications are quickly changing

For the past dozen years since the GFC, the overall environment for fixed income investors has been largely unchanged. Global growth has been sluggish across the developed and emerging markets. Central banks have unleashed a range of programmes aimed at supporting growth and financial assets. And fixed income investors have been persistently rewarded for positioning for low nominal yields, low real yields and a low-inflation (or even disinflationary) environment.

Whether it’s government bonds, credit instruments or even trends in the equity markets, these powerful trends in yields and inflation have significantly influenced the return outcomes of a vast swath of financial instruments.

This backdrop, to which investors have grown accustomed, is quickly changing, and we think investors need to position for a different and more complex environment. In our view, this is not a one-quarter or two-quarter shift, but likely the beginning of a multiyear transition to a different fixed income world.

What characterises this new environment?

It’s continued aggressive monetary accommodation, coordinated with remarkably high fiscal spending across a range of key economies, that will drive substantially higher growth rates over the near term. For fixed income investors, it means a transition to higher real yields as output gaps narrow globally.

We expect significantly more volatility around real yields in the coming quarters and years than we’ve experienced in the recent past. Intuitively, that’s due to uncertainty about whether this higher fiscal spending will drive quasi-permanent higher growth rates, or whether growth fades as fiscal stimulus eventually fades.

Real yields in perspective

As the chart below highlights, developed market real yields have been in a constant decline over the past 20 years, with acceleration lower after the financial crisis and then again in response to the COVID crisis. Relatively weak growth across the global economy has been the primary driver.

Markets currently appreciate that the growth outlook for 2021 will be strong given the reopening of economies and pent-up demand in many services sectors. However, we think investors under-appreciate how strong the growth trajectory could be after this year. Although declining, fiscal stimulus should support major economies well into 2023. Household savings rates are relatively high and will drive continued consumer spending. And, as consumption patterns change as some forms of work-from-home become permanent, we expect multiyear adjustments toward higher goods spending.

As the chart below highlights, this should all result in significantly above-trend growth in the three major economies not only this year, but over the next three years.

What does a multiyear period of higher growth rates imply for markets?

We are entering a 'period of transition', where strong growth will help close output gaps across the world, and where very accommodative central bank policies will increasingly feel different given these higher growth rates.

For fixed income investors, this should translate into a period of structurally higher and/or rising real yields, reflecting the more persistent and stronger economic backdrop.

We have three key conclusions about the emerging transition to higher real yields.

First, of all the factors that can impact the appropriate level of real rates, we expect that output gaps - or realised growth relative to potential growth - will be the main driver of equilibrium levels. As highlighted in the chart below, this analysis points to continued and sustained upward pressure on real yields in the coming quarters as aggressive policies continue to drive above-trend growth rates.

Second, based on our expected evolution of fiscal policy, monetary policy and expected growth, our 'fair value' view for U.S. and German 10-year real yields at the end of 2021 is -0.20% and -1.45%, respectively or approximately 30 basis points higher than current levels (see chart below).

Third, we expect risk assets to perform well in the intermediate term despite rising real rates. If a rise in real yields is exogenous and driven by a one-off tightening of financial conditions, like the taper tantrum of 2013, risk assets have tended to fare poorly. But if real yields are going up because of stronger growth and closing output gaps, it is generally supportive environment for risk assets.

In addition, just as we are transitioning to a higher real-yield environment, we are also transitioning to a higher realised and expected inflation environment. Perhaps the most significant recent change is credible central bank shifts toward conducting policy explicitly to achieve this outcome. Referencing the chart below, we expect inflation rates to return to levels seen in some of the stronger years since the GFC.

This transition to higher real yields and higher inflation rates poses two main risks to markets and economies. We don’t think these issues surface in 2021, but believe it’s not too early for investor consideration.

  • Rising government bond supply versus growth sustainability. Expanded deficit spending in the U.S., Europe and China is driven by the premise that accelerated fiscal stimulus can kickstart economies into higher and more sustainable growth rates. If this spending has low or negative multipliers to growth, the risk is an environment of upward pressure on yields without higher growth.
  • Rising term premiums. Central bank purchase programs, primarily in the U.S. and Europe, have helped push government bond term premiums to low or even negative yields. Whenever these programs begin unwinding—we do not expect this in 2021—balancing the positives of a stronger growth environment with rising term premiums will likely introduce a different type of volatility into fixed income markets.

Finally, it’s worth highlighting the risk of increasing global divergences. Europe and certain emerging markets may lag in the coming global recovery, particularly versus the U.S. and China. This may result in a more disjointed yield environment globally than has been typical over the past few years, and create opportunities for global investors.

Revisiting our 2021 fixed income themes

Key market themes we identified at the start of 2021 remain intact. With the market movements in the first quarter, we slightly update our views.

  • Earn income without duration. This theme was a key driver of relative returns in the first quarter, as short-duration income sectors such as high yield, bank loans and collateralised assets delivered higher returns than other fixed income markets. We expect continued outperformance on both a relative and absolute basis from these areas. However, with the rise in interest rates in the first quarter, tactical opportunities have emerged in intermediate- or longer-duration sectors, such as fallen angels and rising starts in the non-investment grade markets, BBB rated securities in the investment grade market, and emerging market sovereigns.
  • Position for rising inflation. We expect continued increases in inflation breakeven rates, driven by the U.S. markets. We continue to believe that emerging market currencies are also attractive expressions of a higher inflation theme, although volatility will remain relatively high as U.S. growth expectations rise.
  • Sector and issue selection will drive returns. With relatively tight credit spreads across markets, sector and issue selection will remain key drivers of returns across fixed income. We continue to construct portfolios with an emphasis on secular winners (sectors like telecommunications and media), but are finding attractive opportunities in more cyclical exposures such as commodity-focused companies or countries.

 

Ashok Bhatia is Deputy Chief Investment Officer for Fixed Income at Neuberger Berman, a sponsor of Firstlinks. This material is general information and does not constitute investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. You should consult your accountant or tax adviser concerning your own circumstances.

For more articles and papers from Neuberger Berman, click here.

 


 

Leave a Comment:

banner

Most viewed in recent weeks

Maybe it’s time to consider taxing the family home

Australia could unlock smarter investment and greater equity by reforming housing tax concessions. Rethinking exemptions on the family home could benefit most Australians, especially renters and owners of modest homes.

Simple maths says the AI investment boom ends badly

This AI cycle feels less like a revolution and more like a rerun. Just like fibre in 2000, shale in 2014, and cannabis in 2019, the technology or product is real but the capital cycle will be brutal. Investors beware.

Why we should follow Canada and cut migration

An explosion in low-skilled migration to Australia has depressed wages, killed productivity, and cut rental vacancy rates to near decades-lows. It’s time both sides of politics addressed the issue.

Are LICs licked?

LICs are continuing to struggle with large discounts and frustrated investors are wondering whether it’s worth holding onto them. This explains why the next 6-12 months will be make or break for many LICs.

Australian house price speculators: What were you thinking?

Australian housing’s 50-year boom was driven by falling rates and rising borrowing power — not rent or yield. With those drivers exhausted, future returns must reconcile with economic fundamentals. Are we ready?

Welcome to Firstlinks Edition 625 with weekend update

Is it better to live rich or die rich? While many of us were raised to believe that preserving wealth for the next generation is the ultimate goal, a recent gathering I attended hinted that this mindset may be shifting.

  • 21 August 2025

Latest Updates

Economics

Why super returns may be heading lower

Five mega trends point to risks of a more inflation prone and lower growth environment. This, along with rich market valuations, should constrain medium term superannuation returns to around 5% per annum.

Property

Should housing home people or money?

Australia’s home ownership dream is fading as prices soar beyond the reach of many. To achieve affordable prices, the way that Australians view housing as a means of building wealth may need to change.

Retirement

Retirement income expectations hit new highs

Younger Australians think they’ll need $100k a year in retirement - nearly double what current retirees spend. Expectations are rising fast, but are they realistic or just another case of lifestyle inflation?

Economy

Mitigate or adapt: the climate challenge

When change comes we have three paths: ignore it, try to soften its blow, or adapt to it. Australia leans hard on mitigation for climate change but neglects adaptation, leaving us exposed and unprepared.

Retirement

The three key drivers of a purposeful retirement

The concept of retirement is evolving for Australians, with new research showing a desire to work post-retirement and prioritize social connections. Quality financial advice and ‘practising’ retirement activities are key.

Investment strategies

Australia’s moment? De-dollarisation gains momentum

Global credit markets face a fundamental shift as US dollar dominance wanes. Australian investment-grade credit, with attractive spreads and stability, may emerge as a key beneficiary in this structural capital reallocation.

Economy

AI is more smoke and mirrors than a revolution

AI hype oversells machine 'intelligence', masking its true nature as pattern replication. This flood of synthetic content threatens trust and fairness - underscoring the enduring need for thoughtful human oversight.

Sponsors

Alliances

© 2025 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.