The yield you see quoted in the news for a bond is called the “nominal” rate. For instance, as I write this article the yield on the 10-year Treasury Bond is 1.4%. That is the nominal rate. It means you would earn interest of 1.4% per year on an investment in that bond.
In finance, we also are interested in knowing what that yield would be after adjusting for inflation. Recent data shows that inflation, as measured by the Consumer Price Index, is at 6.8% (November).
If we subtract the 6.8% inflation from the 1.4% bond yield, we get -5.4%. This inflation-adjusted yield number of negative 5.4% is called the “real” yield. Do you see the problem?
Saving and investing is the process of forgoing spending money today on goods and services, and letting it grow so you can spend it some time in the future. The goal in investing is to have the money grow at a sufficient rate so that you are able to purchase more in the future than you could purchase today.
The current interest and inflation rates mean your savings will be able to buy 5.4% less goods and services in the future. That’s not good, and it is not normal.
On average, for the past 70 years, an investment in the 10-year Treasury Bond would have provided a “real” yield (the yield above the rate of inflation) of 2.2%. In fact, the current real yield of -5.4% is a record low. I have been using the 10-year Treasury Bond as an example, but this negative real yield situation exists for almost all investment grade bonds in the U.S. today.
Why is this happening? Who is buying bonds at these low rates? There are a couple of answers.
The Federal Reserve has been buying bonds with money that they create with the press of a keystroke. It is called quantitative easing. However, the Fed has recently started to cut back on their bond buying and are on pace to be done buying bonds in March.
Also, in this era of COVID-19 concerns, some bond buyers are valuing the safety of bonds more than their return. Another buyer is global investors who see the low nominal rates on U.S. Treasuries as attractive relative to the even lower rates in countries like Japan and Germany.
Another factor impacting investors’ willingness to buy bonds at these low yield levels is the expectation that the inflation rate will decline by some amount during the next year or two. While Federal Reserve Chairman Jerome Powell has retired the word “transitory” from his description of the current inflation environment, he (and many others) expects inflation to moderate. If inflation does moderate as anticipated, the real yield on bonds will improve.
The concern I have is that inflation might not moderate enough to make today’s interest rates attractive. Some amount of the inflation we are experiencing is going to be persistent.
Therefore, I believe nominal interest rates will have to rise. When the Fed completes its exit from the bond buying business in March, they are expected to start raising short-term interest rates. The Fed’s forecast shows they expect to raise interest rates three times in 2022.
When interest rates rise, the price of bonds declines. For example, if the interest rate on the 10-year Treasury Bond were to rise by one full percentage point today (from 1.4% to 2.4%), the price of that bond would drop by 9%. So, you can see that if interest rates rise, bonds would perform poorly.
Considered alone, rising interest rates are bad for stock prices, too. Stocks are only worth the present value of their expected future earnings and dividends. Just like with bonds, when you increase the interest rate used in that calculation, the present value goes down. However, if the earnings outlook for stocks is going up, that could overcome the issue of higher rates.
I believe there is significant demand for goods and services in the economy. Economic growth is being held back by supply chain issues. These problems should improve during the next six to 12 months. As they do, I expect to see continued positive economic growth.
Corporate earnings will be able to continue to grow in that environment, and I expect stocks will be able to produce a good return even in the face of higher interest rates. We are emphasizing investments in bonds that are less sensitive to changes in interest rates and stocks with reasonable valuations. I believe that combination will be able to produce a good “real” return.