Longer-dated US Treasuries – those with maturities of 5 years or longer – continue to struggle. At best, coupon payments are keeping investors relatively flat. If they own anything longer than 5-year maturities, however, they are down over the last 12 months on a total return basis. This problem is affecting US corporate debt as well. That’s because tighter spreads over Treasuries have been more than offset by rising risk-free rates.
This fact is confusing to many investors because they think lower inflation, such as what we’ve seen over the last year, is always good for bond prices. Inflation expectations embedded in Treasuries are, in fact, lower by 0.4 to 0.5 percentage points over the last year. And, as the following chart shows, while the trend has been choppy, it has also been persistently to the downside.
The problem is that inflation expectations alone do not drive nominal rates; real interest rates also play an important role. The yields that investors see on the screen are the addition of expected inflation and real interest rates. The chart below shows that real rates have increased over the last year by 1.6 to 1.8 percentage points. This more than offsets the decline in expected inflation and explains why Treasury prices continue to drift lower.
How much longer can real rates rise, and where might they eventually settle? To answer that question, we need to look at their long-run history. The following chart shows 5- and 10-year real Treasury yields from 2003 to the present.