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A real interest rate benchmark to watch in 2015

You’re unlikely to find stories on real (inflation-adjusted) interest rates on the financial front pages. But real rates are of major interest to economists and investment strategists. Many strategists think real interest rate trends are key in determining the level of asset prices: while falling real interest rates can boost market valuations, rising real rates may drag down returns across the board.

In many countries there’s a limited history of real rates. To work out their past level you need nominal interest rates and a history of inflation expectations. The path tracked by nominal interest rates is easy to find but measuring inflation expectations over time is tricky.

Fortunately, in the UK there’s a readily available thirty-year history of real interest rate data in the form of the FTSE Actuaries UK Index-Linked index series. This series includes both price and yield data for the UK Government’s index-linked gilt market, one of the oldest inflation-linked debt markets in the world.

The market for US inflation-linked government bonds, called Treasury Inflation-Protected Securities (TIPS), is younger, having started in 1997. Many other governments now issue inflation-linked bonds, including those in Australia, France, Italy, Germany, Canada, Japan, Mexico, Turkey, Brazil, South Africa, Spain, Sweden, Greece and Israel.

In the chart we show the real yield on the FTSE Actuaries UK Index-Linked All Stocks index, which includes all index-linked gilts in issue, over the last ten years. The real yield calculation is based upon a 3% inflation assumption.1

It’s one FTSE benchmark that enables investors to monitor a key indicator of global financial health.

 Real Yield of FTSE Actuaries UK Index-Linked All Stocks Index

 

Source: FTSE, data as at 17 March 204 to 16 December 2014. Past performance is no guarantee of future results.

Since 2011, the real yield on the index-linked bond market as a whole has been negative and the indicator as yet shows no sign of turning up.

Here is a chart of 10-year US TIPS yields since 2004. Since the financial crisis, US inflation-linked bonds have also seen their real returns dip into negative territory.

Real Yield on Constant Maturity 10-Year TIPS

Source: St. Louis Fed, data from 2 January 2004 to 18 December 2014. Past performance is no guarantee of future results.

Even though falling real rates may boost asset prices, they don’t please everyone. For a start, negative real yields mean savers are failing to receive a positive post-inflation return on their cash, at least if lent to the government. If you buy an index-linked gilt with a real yield of -1% a year and hold it to maturity, you are locking in an annual return of inflation minus 1% over the life of the bond.

Many observers link negative real rates to recent central bank policy in the form of near-zero official interest rates and programmes of quantitative easing (QE).

“Long-term asset purchases may have compressed real term premiums on long-term government bonds in the United States and United Kingdom. A reduction in the real term premium, in turn, may explain part of the increase in the equity premium,” the IMF observed in its April 2014 World Economic Outlook.2

In its Outlook, the IMF links the steady decline in real interest rates to longer-term trends: to the substantial increase in saving in emerging economies, to portfolio shifts from equities to bonds and to a decline in the investment rate in developed economies.

The IMF is cautious about the prospects for a sharp rise in real interest rates.

“No compelling reasons suggest a return to the average level observed during the mid-2000s (that is, about 2 percent),” the IMF wrote in the report.

Real interest rates may not be a glamorous indicator, but they are important. Given its recent decline to historic lows, the real yield on the UK’s index-linked government bond market may be a benchmark to watch in 2015.

 

[1] Because of a technicality in the way inflation-linked bonds work, you need an inflation assumption to calculate real yields. FTSE also calculates real yields based on 0%, 5% and 10% inflation assumptions.

[2] http://www.imf.org/external/pubs/ft/weo/2014/01/pdf/text.pdf

 

 

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