Monetary authorities and investors have created a fascinating situation in which real or after-inflation interest rates are at record negative levels. With the 10 year US Treasury yield at 1.45% and trailing one year inflation of 6.2%, the real return would be negative 4.75% assuming that 6.2% inflation persisted for the next ten years.
A better way to view this relationship is to compare Treasury yields with the expected rather than trailing rate of inflation. The expected rate of inflation can be calculated by subtracting the yield on Treasury Inflation Protected Bonds (TIPS) from that of regular US Treasury bonds of the same maturity. US TIPS data has only been available since the early 2000’s which limits this analysis to a twenty-year time frame. Using this methodology, the following chart depicts the real yield on the 10 year US Treasury Bond. Note that we are at or near record lows.
Today’s Treasury yield of 1.45% and expected ten year inflation of 2.55% get you to a real yield of -1.1%. What does that mean? An investor who purchases a bond at these levels can expect a little more than a 10% cumulative decline in the purchasing power of her investment over the ten year time frame. On the other hand, a borrower will benefit by repaying principal with 10% cheaper dollars. Both assume that the market’s current forecast of 2.55% inflation turns out to be correct.
While the Federal Reserve controls very short term interest rates, yields on ten year securities are determined by market supply and demand. So, why would an investor purchase a security with the prospect of a negative real return? First, the largest buyer of these securities is the Federal Reserve which has been supporting markets continuously since the Great Financial Crisis. Second, rates are even more negative in some countries which makes US Treasuries attractive to foreign buyers on a relative basis. Third, bonds provide diversification in most portfolios by serving as a hedge against severe stock market declines. Finally, pension funds and other institutional investors are required to maintain positions in fixed income securities irrespective of their yields.
Negative real yields are great for borrowers and provide considerable support to the stock market since bonds are not an attractive alternative to many investors. One concern is that these yields push investors who must own bonds toward longer maturity and lower credit quality issues in order to eke out at least a modest amount of real return.
Of course, no one really knows where we go from here. Are negative real yields the “new normal” or do investors eventually demand higher returns? And, given the massive amount of US Government debt that must be refinanced over the next couple of years, can the monetary authorities really allow nominal rates to rise? You have probably heard the phrase “an enigma wrapped up in a conundrum.” Well, this is one of many that investors are currently facing!