The unique economic number to watch (part 2)
By Donald Gould
In this two-part article, I suggest that if you could only look at one economic indicator, it should be the 10-year inflation-protected US Treasury interest rate, or TIPS for short. The TIPS bond pays a return indexed to inflation. The principal and interest of the bond grows at the rate of inflation, making it a very attractive investment for those who wish to protect the value of their portfolio against unforeseen inflation. More details on TIPS are contained in Part 1, published in last week’s Courier.
In the first part, I focused on how the TIPS interest rate, together with the standard Treasury bill interest rate, gives us a good idea of consensus inflation expectations. This week, I’ll discuss how the TIPS yield can also capture: (1) an idea of the long-term outlook for economic growth, and (2) the current risk-free rate of return, against which all other returns. investments are calibrated. .
Discover the first part of this series
The “real” interest rate
Economists speak of two types of interest rate, “nominal” and “real”. Nominal interest rates are what we are used to talking about. A newly issued standard 10-year US Treasury bond pays around 1.6% interest per year. This is its nominal interest rate. Its real interest rate is what you have left after adjusting for inflation. The formula is very simple:
Real interest rate = nominal interest rate minus inflation rate
Nominal interest rate = real interest rate plus inflation rate
The graph opposite illustrates these relationships.
For example, if we forecast annual inflation of 2.5% per annum over the next ten years, the real interest rate on the standard 10-year treasury bill would be 1.6% minus 2.5%, or negative 0.9%. Unfortunately, this means that the bond is expected to lose purchasing power over its lifetime. (FYI, it’s much worse for the Garden Variety Bank deposit – with an interest rate effectively at zero, it can be expected to lose 2.5% of its power. purchase every year for years to come.)
As investors, we are ultimately concerned about the real rate of return. A positive real rate of return means that we have preserved and even increased the purchasing power of a portfolio over time. You make long-term investments to accumulate assets that will one day be used to cover your daily cost of living, for example in retirement. Preserving purchasing power is of paramount importance if assets are to achieve this goal.
To illustrate why it’s the actual return that matters, we ask this question: When is a 4% return better than a 7% return? Answer: If the 4% return is achieved in an environment of 1% inflation, it is greater than a 7% return which is accompanied by 5% inflation. In the first case, your purchasing power increased by 3% (4% minus 1%), against only 2% (7% minus 5%) in the second case.
TIPS rate as a barometer of economic health
The real interest rate is extremely useful as an indicator of general economic health. Freed from the inflationary component, the real interest rate reveals the most economically relevant measure of the cost of borrowing money, which in turn tells us a lot about how the economy is doing. door. When the economic outlook is bright, businesses increase the cost of money (the real interest rate) because there are many profitable opportunities to make that money grow. For example, the borrowed funds could be used to develop an improved product, build a new factory, or launch an advertising campaign.
The beauty of the TIPS interest rate is that it tells us the real interest rate, without having to estimate future inflation. The yield on a TIPS bond is equal to its stated rate plus regardless of inflation. Thus, the interest rate declared on a TIPS bond is, by definition, the actual interest rate at all times.
The chart that worked in last week’s column shows the interest rate on 10-year TIPS over the past five years. The rate has generally trended downward over the past 2 1/2 years, with the exception of a brief spike at the start of the pandemic, when financial markets experienced a momentary dislocation. The steady decline in the rate of TIPS over time coincides with a general decline in the rate of economic growth in the United States and other developed economies. Watching the TIPS rate will tell you when the markets’ view of future economic growth rates has changed, for better or for worse.
TIPS rate as a benchmark for all returns on investment
Generally, US government bonds (including TIPS) are considered the least risky investment. Therefore, they provide a basis for comparing expected returns from all other investments. As you might assume, the additional return we expect from an investment in another asset – for example, stocks – is proportional to the amount of additional risk we have to accept.
Over the past century, US stocks have averaged around 5% per year above US government bonds, which in turn have returned around 2.5% per year relative to inflation. Thanks to the TIPS interest rate, we know that today US government bonds will fall about 1% per year below inflation (yes, below) in the years to come. If stocks continue to gain 5% a year over bonds (a big one, of course), then stocks will only come back on average about 4% on inflation. This 4% real return is well below their historical average real return of 7.5%.
This has major implications for investors. Historically, a balanced portfolio (eg, 50% stocks, 50% bonds) has averaged around 5% per year above inflation. Given the current very low (indeed negative) real interest rates, this same portfolio could earn a paltry 1.5% on inflation in the years to come. The impact of this situation would be passed on most heavily to young investors who are still at the beginning of the asset accumulation phase of life. Possible responses include working more years before retirement, taking more risks, or reducing what you spend now and / or in retirement. There are no easy answers.
If the 10-year TIPS rate rebounds to past levels, we would expect generally higher investment returns going forward. You can track the 10-year TIPS interest rate daily at https://www.treasury.gov/resource-center/data-chart-center/interest-rates/pages/TextView.aspx?data=realyield
Don Gould is President and Chief Investment Officer of Gould Asset Management of Claremont.