Recently, more and more economists and economic agencies, like the International Monetary Fund, have been arguing that our expectations of economic growth in the world need to be revised downward because it has become more and more apparent that many major countries in the world need to correct structural problems in their economies.
The problem is that until these structural problems are corrected, economic growth will be much lower than it has been over the past fifty years or so.
Why is this important for people interested in investing in bonds? Well, the answer depends upon how you believe that market interest rates are determined.
If you believe, as I do, that longer-term interest rates are built up from investor’s expectations for the real rate of interest and investor’s expectations of inflation, it is very important. For example, if the expected real rate of interest is 3.00 percent and inflation, for the life of the bond, is expected to be 2.00 percent, then the nominal rate of interest would tend to be around 5.00 percent…the sum of the real rate of interest and expected inflation. A lower expected real rate of interest would mean that our expectation of the nominal rate of interest, given our existing expectation for inflation, would fall.
Economists argue that, over time, the real rate of interest roughly equals the real rate of growth of the economy, that is, in the case of the United States, the rate of growth of real Gross Domestic Product (GDP).
From about 1960 to the end of the century, economists expected that the long-term real rate of growth of the economy would be around 3.00 percent. That is why I chose this rate for the estimate of the real interest rate in the example given above.
Thus, when inflationary expectations are vey low, given this expected real rate of interest, the nominal interest rate will be relatively low, as it was in the early part of the 1960s when inflationary expectations were not large. The 10-year US Treasury security yielded around 4.00 percent during this time.
In the early 1980s, when inflation reached into the double digits, the yield on the 10-year Treasury securities rose into the 15.00 percent range. As inflation was brought under control and inflationary expectations dropped, the nominal yield on Treasury securities declined.
During the latter half of the twentieth century, estimating that the real rate of interest was around 3.00 percent was very useful and seemed to be entirely consistent with real economic growth at the time and the expectations the investment community held about inflationary expectations. Thus, using this model to explain or to forecast longer-term interest rates proved to be very helpful.
However, expectations can change over time. In the examples given above, it was assumed that the expected real rate of interest would remain constant and expected inflation would change as economic conditions changed.
Now, given the feeling of so many analysts that the United States is now experiencing a period of “stagnation”, maybe we need to look at our assumption about what expected the real economic growth of the economy might be. Maybe we need to lower our expectation of what the real rate of interest is. And, maybe that is what we are seeing in the current bond market.
To try and get some perspective on this, let’s look at another estimate of the real rate of interest, in this case we look at the Treasury’s Inflation-Indexed securities. Many analysts, myself included, use the yield on the 10-year Treasury Inflation Protected securities (TIPS) as a rough estimate of the real rate of interest. Note that we don’t have data going back as early as used above since TIPS were only issued beginning in 1997.
In the period between January 2003 and the fall of 2007, the yield on the 10-year TIPS security cycled around 2.25 percent. We can use this as an estimate of the expected real interest rate during that time, and this can also be used as a rough estimate of the expected real rate of economic growth during that time. Many analysts contend that the real growth rate of the economy at this time had slowed from the expected real rate of growth, 3.00 percent, from 1960 through 2000.
So between January 2003 and the start of the Great Recession in December 2007, a nominal yield on the 10-year Treasury bond 5.00 percent would allow us to calculate that investor’s estimates of inflationary expectations was around 2.75 percent.
But, we are interested in the current time period. The yield on 10-year TIPS is in the 0.40 percent to 0.60 percent range. (Note that a year earlier, the yield on this security was in negative territory. I have written in earlier posts for LearnBonds that this negative rate was achieved due to large flows of risk averse monies from Europe that sought “safety” in United States government bonds. This flow created an unusual situation in that it caused yields to become negative for a while. As these funds have returned to a more, financially stable, Europe, the yield has returned to positive territory.)
One reason that the TIPS yield has remained so low is that expectations for the economic growth of the future to be much less than even in the 2003-2007 period. But, from the end of 2007 to the end of 2013, the average real rate of growth of the economy has been slightly above 1.00 percent.
Whatever, it appears as if the “new normal” for expected growth of the United States economy is substantially less than it was in the latter half of the twentieth century. Should it be as low as 0.50 percent or more around 1.00 percent in the future is, of course, unknown. It seems as if market investors are tending to be rather pessimistic about the course of future economic growth.
As investors have become more pessimistic about the expected rate of growth of the economy, they have also indicated that they expect inflation to be even lower in the future. In April 2013, the market showed inflationary expectations to be around 2.40 percent. Currently, expectations are around 2.10 percent. It seems to be consistent that lower expectations of economic growth would be accompanied by lower expectations for inflation.
The question is, what should your estimate of the real rate of interest be? What you choose will impact your expectations for the future path of interest rates. Given the above information it seems as if it might be appropriate to assume that the real rate of interest has dropped.
If you believe that the real rate of interest has dropped to 1.00 percent, then using the market’s expectation of inflation, 2.10 percent, it is not unreasonable to expect the yield on the 10-year Treasury bond to settle somewhere around 3.00 percent. This is a lot lower yield than many people forecasting interest rates are predicting. The current yield on the 10-year Treasury is around 2.70 percent.
One thing some economists write about is that during the Great Depression when a lot of restructuring needed to take place in the economy to finish up the transition from an agricultural society to an industrial society the real rate of interest was historically very low. Suggestions have been made recently something similar has occurred around the time of the Great Recession. If so, our expectations regarding bond rates need to be lowered.
About John Mason
John has been the President and CEO of two publicly traded financial institutions and an Executive Vice President and CFO of a third. He has also spent time as an economist in the Federal Reserve System and worked for a cabinet secretary in Washington, D. C. In addition John taught in the Finance Department at the Wharton School of the University of Pennsylvania for ten years. He now currently has a column on the blog Seeking Alpha and is ranked number 3 in terms of readers on the economy. From this column, two books have been published this past year from earlier blog posts. John is active in the shadow banking world, the venture capital space, and in angel investing. Other than that John works with start ups and early stage organizations, for profit and not-for-profit.
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