A real yield curve is an indicator of risk appetite. Persistently negative real yields are often a
precursor to extended levels of leverage and credit bubbles. When they start to rise they
point to tightening financial conditions which stresses firms’ equity, causing equity volatility
to rise, and causes the credit situation of weaker firms to materially worsen. In the top-left
chart we can see that rising real Fed Funds tends to lead to wider credit spreads about 18-24
months later. Today, this chart is suggesting it may not be until next year we see HY spreads
begin to widen notably. We will, as always, follow our signals for more timely pointers.

That there is a clear link between longer-term real yields and credit spreads – this time
investment grade – can be seen in the bottom-left chart. Whether real yields begin to climb
will be dependent on how aggressively the Fed hikes relative to inflation. The thing to watch
will be the real yield curve. If the Fed is truly successful (or too successful) in tightening
financial conditions across the economy, we would expect to see the real yield curve
steepen. As we can see in the two charts on the right, the real yield curve is a much better
proxy for equity volatility (which is itself very similar to HY spreads) than the nominal yield
curve. Steeper real yield curves mean a higher VIX, wider credit spreads, and higher fixed income

(Click on image to enlarge.)

Real Yield Curve charts

Source: Bloomberg, Macrobond and Variant Perception