Decoding the “Real” Disconnect Between Interest Rates and Inflation
Understanding real interest rates
First off, what are real rates and why do they matter? The rates or yields you see on a bond like the 10-year U.S. Treasury are typically “nominal” rates. “Real” rates are the interest rates that an investor receives after adjusting for inflation—in this sense they are the “real” yield you receive from owning the asset. To illustrate, a Treasury bond that pays 5% in nominal yield per year when inflation is 3% per year would have a real rate of 2%. So, the real rate is determined by the combination of the nominal level of rates and the level of inflation.
The real economics aren’t adding up
Why are markets so focused on real rates now? It’s no secret that nominal rates have been declining for a long time. COVID accelerated that trend as investors flocked to safe haven assets like Treasuries during the crisis. This pushed nominal yields down to record lows, but inflation expectations collapsed as well. In early 2021, as economies opened up and economic growth restarted, demand for Treasuries waned and nominal yields rose. But now, with economies still chugging along and yield-eating inflation rising, investors are piling back into Treasuries. The result is real yield dynamics plunging to record lows in the U.S. with the 10-year U.S. Treasury yield around 1.3%, inflation expectations around 2.3% and a real yield at -1.0%.
Real yields have been pushing more and more negative
10-yr U.S. Treasury yield, inflation, and real yield.
Source: Bloomberg, as of 9/6/2021.
Once again, at current levels, investors who are buying Treasuries now are essentially expected to earn NEGATIVE 1.0% in real yield annually. The economics just don’t make sense.