WHAT DO NEGATIVE REAL RATES MEAN?
Real intermediate- to long-term US bond yields have been negative since March 2020. While low real yields can be partially attributed to the Fed’s bond buying program, there is likely something else at work here.
Bond yields are typically higher than inflation, but there have been times when this has not been true – in particular, during periods of high inflation when supply shortages are the issue. As we showed in a recent paper, during the shortages of the post-World War II era (1946-1948), inflation hit 20%, yet bond yields remained in the 2% range, resulting in a real yield of about -18%. During the OPEC oil embargo of 1973, inflation hit 12.2%, but real yields remained at a decidedly negative -5% throughout the crisis. Real yields did not turn positive until 1975, almost 2 years after the embargo itself. In both cases, it appears that the bond market believed the high inflation of those eras to be “transitory,” even though it lasted for two to three years.
It is possible that the bond market is once again, in its collective wisdom, telling us that the current bout of inflation will also be temporary. After all, inflation has been high for less than a year, and by 1947 and 1973 standards, is still modest. Of course, now we have better measures of long-term inflation expectations. If higher expectations become embedded, economic theory tells us that is a self-fulfilling prophesy. I can tell you from experience that when inflation reached 14.6% in March 1980, the general feeling was that high inflation was going to be a way of life. I was taking an economics course at the time, and I remember the professor saying that we could live with 10% inflation indefinitely. And that’s what we expected back then, along with a standard 10% cost-of-living raise. Real yields accordingly turned positive in late 1980, reflecting a widespread belief that inflation had become anchored at high levels.
The bond market of today is saying we’re not there yet. The Fed is likely moving to keep it that way. Even so, we should not expect real bond yields to necessarily become positive. In fact, that is not likely, based on history. But it’s something to watch carefully.
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