Real Interest Rates

Today we’ll talk about real interest rates and what that means to our current situation. I left off yesterday’s discussion with the general concept that since ‘real’ interest rates are around 1% in the US, then that implies that the long run return on capital is also 1%. This is for government debt, which is theoretically a risk free rate. These rates are found by looking at treasury inflation protected securities, also known as TIPs. (For those who are unfamiliar, TIPs carry a coupon which reflects the real interest rate an investor will receive, while the principal paid back at maturity is adjusted by the change in CPI over the life of the bond). While this market is not as big as the market for regular coupon treasuries, the amounts outstanding is well into the hundreds of billions of dollars, and in my opinion, contains lots of good market observations.


In the attachment, I have laid out the “real yield” histories for inflation linked bond of various countries, to see if there are analogies to the real yields available on dollar denominated TIPs, versus those for government securities, denominated in the local currency. The trend in real yields in the US has been declining over the last 12 years, for which history is available. While one could say that the drop in 10 year treasury rates for the last 30 years reflects a decline in inflation and inflation expectations, TIPs isolate the real return, from the nominal treasury yields which includes inflation expectations. This leaves me trying to figure out what factors are at work to reduce real returns, as denoted by steady decline in TIPS yields.


What is interesting about the TIPS history is that yields spiked in the fall of 2008, when the financial crisis was wreaking havoc on the financial markets. Why did TIPS yields spike higher then? My basic conclusion has to do with the fact that assets values in the US’s multi-trillion dollar mortgage markets were imploding during that time period, which in turn created a cascading demand for money, since most of these mortgage assets were leveraged, and the owners needed to post more equity. Demand for money, and specifically US dollars, where the epicenter of asset price implosion was occuring, was so great that the US Fed had to lend over $1 trillion to various financial institutions so they could meet their funding requirements. Despite the tremendous amount of liquidity provided by the Fed, real yields spike higher. In fact, inflation expectations were negative at the time, indicating the market’s perception that deflation was coming. Accordingly, due to this demand for money, real yields shot up over 150 bps in a short period.


A tour of the real yields in other currencies is limited by the number of governments which issue such securities, and the fact that this history only extends back into the mid 1990s. See the next few graphs on the attachment. Here are some basic observations which the charts tell:


1> The real yields in France and Canada seems to follow the same basic levels of dollar denominated TIPs since the late 1990s, and now also yield around 1%;


2> While Aussie inflation linked bonds have dropped from the 4s in the 1990s, those yields never reached the 1% level of real yields in the US, Canada or France. Accordingly, Australia, with its commodity based economy, which has been doing well as of late, does sport better real returns than its western counterparts;


3> Japan does not have as much data on real rates, as these securities are a recent phenomenon for them, so there is not so much to say about the history of their real rates, except for the fact that their current real rates are in the low 1s, like the other countries;


4> The 2008 spike in real yields was most noticeable in the US, where rates spiked about 175 bps during 2008. Canada followed a similar pattern and experienced a spike of almost 150 bps, while France and Australia was almost unaffected with a spike that was barely 50 bps. Japanese real rates spiked the most of all, but I cannot come up with a good reason for it.


5> Brazil, not shown on the charts, is the only BRIC country with inflation linked sovereign debt, and their rates are in the 6s, indicating much higher real rates of returns in that economy.


This of course leads me to question why real returns are low in the western economies. By contrast, real rates in Brazil are over 6%, and over 2% in Australia where the commodity based economy is apparently doing better than ours. If China had free markets and inflation protected securities, I would think that real rates of return would be similar to Brazil. According to Bloomberg data, neither India or Russia, the two other BRIC countries, have inflation indexed bonds.


For a moment, I want to reiterate the punch-line from yesterday’s blog: that western economies need to find ways to improve the return on capital in the local currencies. This can be accomplished by altering work place rules, health care burdens on corporations (not going to happen under Obama), and other fundamental rules and expenses, which makes it less economic for companies to  build and operate new businesses/factories in the US. Hopefully the business leaders gave that message to Obama this morning. In a very simplistic way, the absence of real rates of returns means that our nation’s prospects for kicking the problem of chronic unemployment might go on for much longer. 


There is not enough data on how TIPS traded during the last great recessions, but some lessons can be taken from the data which is available during the 1970s. In the 1970s, the last period where the economy was mediocre for an extended period of time, inflation had a few spikes. As the next graph on the attachment shows, from 1973 to 1975 and again from 1978 to 1980, inflation rose above the yields of 10 year treasuries, and as such, real interest rates were negative. As the next graph of the US unemployment rate shows, these time periods led to spikes in unemployment, in early 1975, and again in 1980. So, in a very unscientific way, I believe that low real rates of return also correlate with reduced economic activity and high levels of unemployment.


Unfortunately, one way to increase the real rate of return on dollars is to engage in tight monetary policy, the opposite of what is going on now. For instance, monetary conditions tightened on their own during the financial crisis of 2008, and real rates spiked to 4%. When the Fed tightened in the early 1980s, that drove US rates much higher, and eventually led to a deep recession, but ultimately spawned the great bull market which took US stock indices up by a multiple of greater than 12 times over an 18 year period.


There are other ways to increase real rates of returns, but that usually involves being able to invest in new technologies, and similar activities with a high rate of return. And these investment opportunities need to be prevalent enough to move the trillions of dollars of capital invested in US treasuries, and into these sorts of endeavors. In short, our government needs to be investing in the sorts of R&D which will lead to new inventions, and ways of doing business. Consistent with that, we should be providing incentives for young people to pursue engineering and scientific degrees in college, which could lead to new technologies and inventions.


* The spike in US rates has caused the differential between the dollar rates and those in foreign countries to increase, and should ultimately cause the dollar to do well over the very near term. Take a look at the last chart on the attachment which shows the difference between yen rates and dollar rates, the orange line, which has spiked higher over the last couple of weeks. The exchange rate between the yen and dollar, yellow line, which has shown a remarkable correlation, is now lagging. Based on the way the chart lays out, the yen/dollar exchange rate could move over 4 yen to 88 Yen/dollar. The same applies to other currency relationships with the dollar. Expect the dollar to do well over the next couple of weeks. 


** Accordingly, other markets which have been inversely correlated with the dollar, like stocks, commodities and precious metals, should do poorly as the dollar does better. Expect these markets to sell-off going into year end.


* Jim Rogers - was on CNBC last week, talking about how bearish he was on US Treasuries, and on the prospects for much higher interest rates. He said that if you are in the bond business, then you should be looking for another line of work. Thanks Jim!