What is the Relationship Between Interest Rates and Inflation?

Real-time Interest Rates

How important are actual rates? Bond rates and yields, like the 10-year US Treasury, are often “nominal.” Real rates are the interest rates an investor obtains after inflation is factored in. For example, a Treasury bond paying 5% nominal return with 3% inflation has a real rate of 2%. So the real rate is decided by the nominal rate and inflation.

The numbers don’t add up.

Why are real rates so important now? Nominal rates have been falling for a long time. During the crisis, investors flocked to safe haven assets like Treasury bonds. Nominal rates fell to historic lows, but so did inflation expectations. As economies opened and growth resumed in early 2021, demand for Treasuries dropped and nominal yields climbed. Now, with the economy still humming along and inflation rising, investors are returning to Treasuries. As a result, the 10-year Treasury yield is about 1.3 percent, inflation expectations are around 2.3 percent, and the real yield is around -1.0 percent.

The 10-year Treasury yield, inflation, and real yield have all been declining.

The 10-year Treasury bond’s nominal, inflation, and real rates. It demonstrates that real yields have been declining since 2018, now at -1.1 percent.
Bloomberg, 9/6/2021.

Again, at current levels, investors buying Treasuries may expect to earn a real yield of -1.0 percent annually. The math doesn’t add up.

Decoding the “real” rate-inflation disconnect

So, since Treasury economics are clearly distorted, who keeps buying these negative real yielding assets? While ongoing virus fears may be impacting longer-dated Treasuries, a number of “non-economic” investors are driving down nominal rates. Let us examine these investors more closely:

Foreign investor demand: As the US economy reopened, foreign goods imports grew dramatically. For their foreign exchange reserves, these exporting corporations and countries have bought US debt. Moreover, while nominal yields are low in the US, they are significantly lower globally. The (relatively) high yield on US Treasuries has attracted many overseas investors.
Big institutions rebalance: Low-interest rates force huge institutional investors like pension funds to rebalance. Without going into the weeds of pension accounting, many pension plans must buy Treasuries to fund future commitments and cash flows. They must buy more Treasuries to cover their future liabilities when rates decline. As a result, major investors continue to buy.

Adding to the momentum: Many algorithmic investors now hedge portfolios by promptly responding to rate changes. These momentum traders have recently changed from selling US Treasuries to purchasing them (buying U.S. Treasuries). Adding incremental demand.

What triggers an increase in real rates?

All of these investors have one thing in common: they aren’t buying Treasury bonds because they are inexpensive or have a high long-term return potential.

Not being in sync with the current macro story will not be a trigger for higher nominal rates (and thus real rates). The market already knows this. Instead, a confluence of variables may shock investors who have been slowly nibbling on Treasury bonds. It might be unexpected job growth, larger fiscal spending increases, earlier Fed rate hikes, or the conclusion that “transitory” inflation may last much longer than predicted.

For non-economic participants, the most effective catalyst may be a sharply positive real growth surprise, reviving real rate economics and considerably raising nominal rates. However, considerable excess liquidity in the financial system will make it difficult to relocate the excess demand for longer safe assets.

Positive real rates for bond investors?

Low nominal rates in Treasuries lead to low yields elsewhere in fixed income markets, which is problematic given rising inflation. In July, Core CPI inflation was 4.3 percent. In terms of nominal yield, only 3.7 percent of bonds in the Bloomberg Barclays Multiverse Index (a proxy for the global bond market) yield over 4%. It is an obvious headwind for fixed income returns right now.

Looking at inflation over a 5-year period reveals how difficult it is for nominal rates to overcome. A real yield is calculated by subtracting the current nominal yield from the market estimated inflation rate of 2.5 percent over the following five years.

Inflationary pressures on real yields
Sectoral nominal and real yields

Real and nominal rates for fixed income sectors. On the other hand, non-investment grade bonds are still yielding positive real rates.
Bloomberg, 8/31/21. Real rate = nominal yield-to-maturity minus 2.5 percent inflation breakeven rate. The Bloomberg Barclays US Aggregate Bond Index. Bloomberg Barclays US MBS Index represents US Mortgages. The Bloomberg Barclays Investment Grade Corporate Index. American High Yield Corporate Index (Bloomberg HYCI). Indicator of J.P. Morgan EMBI Global Core Index.

Treasuries, mortgages, and investment-grade corporates all have negative annual real yields. The predicted real yield on the Aggregate Index, which is widely used as the core of bond portfolios, is -1.1 percent for the next 5 years. Investors seeking low single-digit real yields must go to lesser quality securities such as US high yield corporate bonds or dollar-denominated developing market debt.

Clearly, bond investors have difficult options. Staying secure with good-grade bonds leads to negative real yields. The risk of default, volatility, and potential linkage to equities increases when investing in poorer credit grade instruments like high yield and developing market debt.

In short,

If growth does not surprise, real rates will likely continue low, with room to gently climb as non-economic demand drivers subside. Many bond investors seeking higher nominal yields have gravitated to riskier sections of the fixed income market. This method sacrifices bond allocation safety and diminishes diversification potential in a bear market. That makes reworking the 60/40 portfolio concept more important than ever.