The Surprising Consequences of the Global Frenzy for Positive Yield

January 28, 2015

As the dollar soars, so does the real yield on bonds denominated in dollars.

As central banks rush to depreciate their currencies and push yields into negative territory, what's becoming scarce globally is real yield in an appreciating currency. Real yield is yield adjusted for inflation/deflation: if inflation is 3% and bonds yield 2%, the real yield is negative 1%. If inflation is negative 1% (i.e. deflation), and the yield on bonds is .1%, the real yield is 1.1%.

What's the real yield on a bond that earns 1% annually in a currency that loses 10% against the U.S. dollar in a year? Once the foreign-exchange (FX) loss/gain is factored in, the investor lost 9% of his investment.

Needless to say, the real yield must include the foreign-exchange loss/gain. An investor earning 10% in a currency that's losing 20% annually against other currencies is losing 10% annually, despite the apparent healthy nominal yield.

An investor earning 1% in a currency that's appreciating 10% annually against other major trading currencies is earning a yield of 11%. Clearly, the nominal yield is deceptive; the real yield can only be calculated by factoring in both inflation/deflation in the issuing economy and the appreciation/depreciation in the issuing currency against major tradable currencies.

Now we understand why what's scarce globally is real yield in an appreciating currency: the only major trading currency that's appreciating is the U.S. dollar. Any nominal yield on bonds issued in euros or yen turns into a loss when measured in U.S. dollars. Even the Chinese renminbi, which is pegged to the U.S. dollar, has slipped against the dollar as Chinese authorities have responded to the devaluation of the Japanese yen and other Asian-exporter currencies.

One result of the global scarcity for real yield is high demand for U.S. Treasuries, which are denominated in U.S. dollars. High demand pushes bond yields down, effectively replacing the Fed's quantitative easing (QE) bond-buying programs, which the Fed ended last year.

The U.S. gets the benefits of strong demand for its bonds (i.e. low interest rates) without having to issue new money (QE).

Another factor is the reduced issuance of new Treasury bonds as the U.S. fiscal deficit declines. This effectively reduces supply as demand remains strong.

This is a self-reinforcing feedback loop: as the U.S. dollar strengthens and the U.S. fiscal deficit declines, the Fed has no need to buy Treasury bonds (with freshly issued money) to keep interest rates low. Since the U.S. central bank isn't issuing new money while every other major central bank is printing massive amounts of new money to depreciate their currencies, this pushes the U.S. dollar even higher.

And as the dollar soars, so does the real yield on bonds denominated in dollars. That may not surprise everyone, but few can support a claim of predicting this a few years ago.

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