Knowing your real interest rate gives you an idea of what your investment is paying you after factoring in inflation.
The concept of real interest rates or real yields hit the headlines last month, raising growth concerns for global investors. To everyday consumers, the phrase meant little, but to professional investors, it meant returns investors expect to earn after inflation.
Everyday consumers are conscious of interest rates. They know they are earning very little by putting their money in the bank. They are also aware of rising inflation, which has dominated the headlines for several months.
What they haven’t done is put together the concept of how little they really earn on their money in the bank when one strips out the inflation rate. That number is the real rate they are earning.
Investors didn’t pay much attention to the real yield when inflation was low in the sub-2% area. This is because the benchmark 10-year U.S. Treasury yield was trading in the essentially the same area. But since the start of the global economic recovery, yields have stayed near historical levels, while inflation has soared to multi-year highs. This has pushed real rates into negative territory.
Many consumers know the interest rate on their savings account, or the money they earn on their balance. However, they probably don’t know what their real interest rate is. This article will explain real interest rates.
What is the Real Interest Rate?
Simply stated, a real interest rate is an interest rate that has been adjusted to remove the effects of inflation to reflect the real cost of funds to the borrower and the real yield to the lender or to an investor.
In equation form, the real interest rate is simply equal to the nominal interest rate minus the actual or expected inflation rate.
To understand real interest rates, you have to first understand inflation. Inflation is a general, sustained upward movement in the prices of goods and services in an economy.
Inflation matters when making decisions related to interest rates on savings accounts and other financial assets. For example, when you have a savings account, interest is at work increasing the amount deposited, while inflation is at work reducing its value.
What is Your Real Rate of Return?
Knowing your real interest rate gives you an idea of what your investment is paying you after factoring in inflation. It also gives you a better idea of the rate at which their purchasing power increases or decreases.
Treasury bonds are fixed-rate U.S. government debt securities with a maturity range between 10 and 30 years.
Treasury Inflation-Protected Security (TIPS) is a Treasury bond that is indexed to an inflationary gauge to protect investors from the decline in the purchasing power of their money.
To estimate their real rate of return, an investor compares the difference between the current Treasury bond yield and the current Treasury Inflation-Protected Securities (TIPS) yield of the same maturity, which estimates inflation expectations in the economy.
What are Real Yields Telling Us about the State of the Economy and Investments?
Currently, the U.S. economy is in a low-yield, high-inflation environment and is likely to remain there until inflation starts to decline and the Federal Reserve begins to raise interest rates. Because of this, the yield on 10-year Treasury Inflation-Protected Securities (TIPS) is hovering near record lows.
In July 2021, yields on U.S. Treasuries eased after the auction of $16 billion in 10-year TIPS was bid at a record low of -1.016%.
Some analysts believe this means investors are pricing in higher inflation going forward. Other analysts believe this reflects concerns about slowing growth after a strong first half of the year. Still others are saying it’s just a function of mathematics and may not mean anything.
In other words, negative real yields are a function of the expected path of short-term interest rates set by the Fed compared with current and forecasted inflation. So there is no way that term real yields could be anything but negative in July 2021.
With yields this low, investors are throwing money at the stock market. This is driving up prices to unwarranted levels. Although stocks, for example, are overpriced using traditional indicators, investors don’t have a lot of choices if they want to beat inflation.
Negative real yields pose a big problem for pension funds and other long-term asset allocators that are also grappling with equity markets trading at high valuations.
One effect of deeply negative real yields is to buoy a range of other asset classes, as they make the returns they offer more attractive in comparison to bonds.
Real Yields Reflect the Future Investment Environment
Monitoring the direction of real yields offers investors a chance to gauge the state of the economy.
If real yields remain near record lows then this likely means investors believe elevated inflation levels are going to linger and the Fed is going to stand pat on policy. It could also indicate investor expectations of a weakening economy.
If real yields start to move higher then this will tell investors that the Fed may be getting ready to tighten policy by raising rates in the near future. It could also be an indicator of economic growth and lower inflation on the horizon.
