The biggest change on the margin: real yields

Since the beginning of April, real yields have soared, in what is now the biggest change on the margin to be found in the stock and bond markets.

The chart above shows the real yield on 5-yr TIPS, which is up 80 bps since early last month. This measure of real yields is now at its highest level since early 2012. At the very least, a big increase in real yields on TIPS (which is the flip side of a big decline in TIPS prices) is consistent with a big decline in the demand for the inflation-hedging properties of TIPS.

Real yields on 10-yr TIPS are up 60 bps from their early-April levels. This is an across-the-board increase in real yields.

As the above chart suggests, higher real yields on TIPS are likely driven by improving expectations of future economic growth. The rise in real yields also correlates to increasing hints from the FOMC that an end to Quantitative Easing may be coming sooner than the market had expected. But if the Fed is likely to move sooner than expected, the underlying reason is most likely an improving economy.

As the above chart shows, gold prices have dropped rather precipitously since early April. Declining gold prices likely reflect reduced concerns about the inflationary potential of monetary policy, and they could also reflect reduced concerns about the possibility of another recession or economic collapse. Gold, in other words, is consistent with the message of nominal and real yields.

The chart above shows the difference between the nominal yield on 5-yr Treasuries and the real yield on 5-yr TIPS, otherwise known as the market's expected annual inflation rate over the next 5 years. Expected inflation has fallen by about 50 bps since early April, and most of that decline can be explained by a rise in real yields, since nominal yields are up only 25 bps or so.

To summarize, there have been big changes in the bond market in recent months that point to 1) improving expectations for real economic growth, and 2) somewhat lower inflation expectations. Both of these, in turn, are consistent with the 7% rise in the S&P 500 since early April. These are all healthy developments. Perhaps more importantly, these changes are NOT consistent with the view that the equity market is being pumped up by easy money. If easy money were the driving force, we would be seeing higher gold prices and lower real yields.