Bond yields have seen a surprising increase as a result of real interest rates, which could mean both good and bad news for other asset types.----- Transcript -----Welcome to Thoughts on the Market. I'm Andrew Sheets, a Senior Fixed Income Strategist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about trends across the global investment landscape and how we put those ideas together. It's Friday, August 18th at 2 p.m. in London. August is a month in financial markets that is often all or nothing. Sometimes it's quiet, a self-reinforcing state where investors desire to recharge and enjoy the nicer weather means fewer deals and lower activity, reinforcing the desire to enjoy the nicer weather. But there's a flip side. The fact that so many investors' are away in August can also amplify market moves, especially if worries mount, and we see that in the historical data. August has seen the largest average rise in stock market volatility of any month, if we go back to 2010, where it's seen higher volatility in 10 out of the last 14 years. So far, this August is off to another volatile start. The culprits are plenty. Equity markets have been having a great run based almost entirely on expanding valuations, an unusual occurrence, as Lisa Shalett, the CIO of Morgan Stanley Wealth Management and I discussed on this program last week. Data in China has been weaker than expected and across the U.S., Europe and Japan, bond yields have been rising significantly. The bond move is especially notable given how it's been happening. Yields aren't rising because of inflation, as last week's U.S. consumer price inflation reading was a little better than expected, and longer run expectations of U.S. inflation are actually lower on the month. The market also has increased its expectation of further rate hikes from the Federal Reserve or the ECB, although it has added another expected hike for the Bank of England. Rather, the increase in yields this month has been almost entirely due to the so-called real interest rate, that is the yield on bonds over and above expected inflation. In the U.S., ten year real rates are now about 1.9% above expected inflation, which is a similar level to what we saw from 2003 to 2005. There's both bad and good news here. The bad news is that if investors can get a higher guaranteed return over inflation from government bonds, other assets are going to look less attractive by comparison. We continue to hold a more cautious view on U.S. equity markets as well as commodities. But there's also some good news. Higher real rates have made TIPS or Treasury inflation-protected securities more attractive and my colleagues in interest rate strategy like them. The recent volatility in bond markets has cheapend mortgage backed securities, where my colleague Jay Bacow, Morgan Stanley's co-head of securitized products research, has recently moved back to a positive view. And higher yields are improving the funding ratio for many pension funds, encouraging them to buy safer, longer term investment grade bonds. More broadly, higher long term real rates could be a sign that the market is more confident about the long term outlook for the U.S. economy. If we think back to the 1990s, it was a period of higher expected potential growth and higher rates relative to expected inflation. If we think about the sluggish 2010s, it was the opposite with very low rates relative to inflation as the market worried that growth could not achieve escape velocity. It will take years to know if the bond market is really endorsing a stronger long run economic view, but as we hope to emphasize, higher rates aren't necessarily all bad. Thanks for listening. Subscribe to Thoughts on the Market on Apple Podcasts, or wherever you listen and leave us a review. We'd love to hear from you.

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