Evaluating Nominal versus Real Rates | Lord Abbett
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Economic Insights

A closer look at nominal yields, a sharp rise in inflation expectations and the real interest rate.

Read time: 2 minutes

The recent move in real (i.e., inflation-adjusted) interest rates has received significant press coverage. While the move has been sharp, real interest rates remain significantly lower than what we would expect to see in a more normalized environment. For context, the real yield on the five-year U.S. Treasury Inflation-Protected Securities (TIPS) note remains roughly 175 basis points (bps) below where it was at the end of 2019, pre-Covid. We think that despite the recent rise in real rates, there is still plenty of room for them to go higher.

Nominal rates consist of two pieces: inflation expectations (measured by inflation swaps or the TIPS/Treasury breakeven rate) and the real rate. Real interest rates are assumed to be a better indicator of true borrowing cost, given they adjust for inflation. An easy measure of the real rate is the yield on TIPS, although it’s worth noting that several other measures may be used given TIPS yields can be influenced by market technicals (including liquidity and supply/demand balance). Figure 1 shows the nominal yield in blue, the TIPS yield (as the measure for real rates), and the breakeven inflation rate for 10-year U.S. Treasuries.

 

Figure 1. Nominal Yield, TIPS Yield and Breakeven Inflation for 10-Year U.S. Treasuries
10-year data from May 2010 through February 2021

Source: Economic Research Division, Federal Reserve Bank of St. Louis. Data as of March 5 2021.  The TIPS/Treasury breakeven rate is calculated as the difference between the 10-year U.S. Treasury rate and the 10-year U.S. Treasury inflation-indexed security rate. For illustrative purposes only.

 

The initial rise in the 10-year nominal yield starting in August 2020 was driven by the normalization of inflation expectations. Break-even inflation reached a peak of 2.2% on February 17, 2021, before backing off slightly. Over the last two weeks the real rate has taken over as the primary driver of increasing nominal yields.  Since February 10, the real rate has risen 25 bps, a sharp move in a relatively short time. However, it is worth remembering that the real yield remains very low. The U.S. Federal Reserve (Fed) tracks this rate closely to understand how stimulative monetary policy is. Given the rate remains solidly negative, the Fed does not appear concerned about the increase, at least not yet.

The Fed is also focused on the shorter end of the real rate curve, even more so than longer term yields. Figure 2 shows the same decomposition for Five-year Treasuries. Here the increase in real rates is more muted, up 16 bps since February 10, but still lower than where we started the month.

 

Figure 2. Nominal Yield, TIPS Yield and Breakeven Inflation for 5-Year U.S. Treasuries

Five-year data from May 2010 through February 2021

Source: Economic Research Division, Federal Reserve Bank of St. Louis. Data as of March 5 2021.  The TIPS/Treasury breakeven rate is calculated as the difference between the five-year U.S. Treasury rate and the five-year U.S. Treasury inflation-indexed security rate. For illustrative purposes only.

 

If rates are starting to reflect forward market expectations of a change in Fed policy, we are in the very early stages. Our view is that the Fed will leave monetary policy unchanged for the remainder of this year.  While there is a healthy debate among market participants as to when policymakers will start talking about tapering bond purchases, most seem to agree with our view that it is not likely until early 2022. According to market-based measures, the first hike in the Fed Funds rate is not expected until the second quarter of 2023. This is consistent with the interest rate “dot plot” the Federal Reserve produces each quarter.  The combination of increased fiscal stimulus, accommodative monetary policy, and rebounding economic growth as the vaccine rollout accelerates is already leading to higher inflation expectations, as reflected in market pricing. It remains to be seen if the personal consumption expenditures (PCE) index, the Fed’s preferred inflation measure, will reach the Fed’s target of 2%. We remain skeptical considering recent history (PCE rose above 2% only briefly in 2018 and at the end of 2011), but it certainly won’t stop the market from pricing in higher interest rates.

 

The value of investments in fixed-income securities will change as interest rates fluctuate and in response to market movements. Generally, when interest rates rise, the prices of debt securities fall, and when interest rates fall, prices generally rise. U.S. Treasuries are debt obligations issued and backed by the full faith and credit of the U.S. government. Income from Treasury securities is exempt from state and local taxes. Although Treasuries are considered to have low credit risk, they are affected by other types of risk—mainly interest rate risk (when interest rates rise, the market value of debt obligations tends to drop) and inflation risk. The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy.       

Forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.

This article may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

 

TIPS (Treasury inflation-protected securities) are U.S. Treasury securities indexed to inflation in order to protect investors from the negative effects of inflation. The principal of a TIP is adjusted according to the CPI-U. With a rise in the index, or inflation, the principal increases. With a fall in the index, or deflation, the principal decreases. Though the rate is fixed and paid semiannually, interest payments vary because the rate is applied to the adjusted principal. Specifically, the amount of each interest payment is determined by multiplying the adjusted principal by one-half the interest rate. Upon maturity, TIPS pay the original or adjusted principal amount, whichever is greater. Because TIPS are adjusted for inflation, a change in real interest rates (but not nominal interest rates) will affect the value of TIPS. When real interest rates rise, the value of TIPS will decline, and when real interest rates fall, the value of TIPS will rise.

Treasuries are debt securities issued by the U.S. government and secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes.

CPI swaps are a type of interest-rate swap in which the fixed payment is based on the current, expected rate of inflation, while the variable payment is based on the actual rate of inflation. The actual rate of inflation is measured by the cumulative change in the headline Consumer Price Index (CPI), which includes food and energy. The most common type of CPI swap is a zero-coupon swap, so called because the only payment occurs when the contract matures. Thus, there is no cash commitment when a party enters a zero-coupon swap agreement or during the life of the contract.

The information provided herein is not directed at any investor or category of investors and is provided solely as general information about our products and services and to otherwise provide general investment education.  No information contained herein should be regarded as a suggestion to engage in or refrain from any investment-related course of action as Lord, Abbett & Co LLC (and its affiliates, “Lord Abbett”) is not undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity with respect to the materials presented herein.   If you are an individual retirement investor, contact your financial advisor or other non-Lord Abbett fiduciary about whether any given investment idea, strategy, product, or service described herein may be appropriate for your circumstances.

 

The opinions in the preceding commentary are as of the date of publication and are subject to change. Additionally, the opinions may not represent the opinions of the firm as a whole. The document is not intended for use as forecast, research or investment advice concerning any particular investment or the markets in general, and it is not intended to be legal advice or tax advice. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information.

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