Bond investors can cheer real interest rates hitting a 15-year high. That’s because bonds historically have performed better in the wake of higher rather than lower real rates.
The real interest rate is the amount by which nominal interest rates exceed expected inflation. Real rates have been negative for most of the past 15 years — with nominal rates less than expected inflation. But real rates recently turned positive — as you can see from the chart below of the 10-year Treasury
real yield. It currently is double the two-decade average; the last time it was higher was in late 2007.
Real rates may rise even more in coming months. Federal Reserve chairman Jerome Powell recently said that more rate hikes are coming, even as inflation may decline.
It’s important to distinguish between nominal and real rates because sometimes higher nominal rates are justified by higher inflation expectations. In that event, bond investors are on shaky ground if they hope that rates will decline and bonds will rally. In contrast, when real rates are high, nominal rates are higher than justified by inflation expectations—and it becomes a better bet that nominal rates will be declining and bonds rallying.
Now is one of these times when the distinction between nominal and real rates is so crucial. If inflation is coming down in coming months and years, then the current high nominal rates can be expected to come down too. If higher inflation is here to stay, in contrast, then current high nominal rates will remain—or go higher.
As this distinction suggests, correctly determining inflation expectations is key. Doing that requires making a number of assumptions. Currently, according to the Cleveland Federal Reserve Bank’s Center for Inflation Research, expected U.S. inflation over the next 10 years is 2.27% per year.
The Cleveland Fed bases this calculation on a statistical model it has constructed whose inputs include nominal Treasury yields, inflation data, surveys of inflation expectations, and inflation swaps (derivatives in which the interest that lenders earn is a function of inflation). Though this model is not the only approach to calculate expected inflation, the leading alternate measure currently reaches the almost identical conclusion.
This alternate measure is the so-called breakeven inflation rate — the difference between the 10-year Treasury’s nominal yield and the yield on 10-year TIPS. On Jan. 12, which is when the Cleveland Fed last updated its estimate of expected inflation, the 10-year breakeven rate was 2.21% — quite close to the 2.27% that the Cleveland Fed calculated.
Real rates and bond returns
To measure the correlation between real rates and bond returns, I relied on the Cleveland Fed’s data on expected inflation, which extend back further than the breakeven rate — to the early 1980s versus the early 2000s. To measure bond returns, I relied on an index of bonds’ inflation-adjusted total return calculated by Yale University’s Robert Shiller.
The table below summarizes what I found when dividing all months over the past four decades into four groups, according to their real interest rates. Regardless of whether I focused on bond returns over the subsequent 1-, 5- or 10-year periods, bonds earned higher inflation-adjusted returns when real rates at the start of those periods were higher. This pattern is significant at the 95% confidence level that statisticians often use when determining if a pattern is genuine.
|Bonds’ real total return over subsequent year
|Bonds’ real total return over subsequent 5 years (annualized)
|Bonds’ real total return over subsequent 10 years (annualized)
|25% of months in which real rates were lowest
|Second lowest 25%
|Second highest 25%
|25% of months in which real rates were highest
Where do real rates stand today relative to this history? Though they have risen in recent months, they currently are in the second-lowest quartile of the historical distribution. So it would be unrealistic to expect the mouth-watering returns of the highest two quartiles. Still, though, the returns associated with the second-lowest quartile are significantly positive.
What about stocks?
You might wonder if high real interest rates can tell us anything about the stock market. The answer is no, at least as far as my analysis of the past four decades is concerned. I could find no statistically significant correlation between real rates and the stock market’s subsequent return.
That doesn’t mean stocks won’t do well in coming years. It just means that we can draw no conclusion one way or the other based on where current real rates stand. Investors will have to settle with the good news that high real rates have for the bond market.
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at [email protected]