TIPS: real interest rates

All bond holders want to earn a yield that is higher than inflation. With the Fed suppressing interest rates by buying Treasuries and mortgage bonds, the yield has been negative for a while.

I-Series Savings Bonds yield a fixed rate plus inflation, but each investor (or trust) can buy only $10,000 per year. I-Bonds are issued to a specific buyer and can’t be traded. Return of principal is guaranteed as long as the I-Bond is held for a year or more. (Up to 30 years.) The fixed rate of the I-Bond is currently zero, but inflation is high. The yield of I-Bonds currently is 7.12% but starting in May 2022 is expected to be 9.62% for the following 6 months.

TIPS (Treasury inflation-protected securities) do not have a maximum purchase limit and can be traded in the secondary bond market. Like other bonds, the price of a TIPS falls if prevailing interest rates rise.

The yield of TIPS are inflation-adjusted. They are often compared with regular Treasuries to calculate the market’s inflation expectations. An investor who expects inflation to remain higher than predicted will do better to buy TIPS. I bought 10 year TIPS in late 2008 when the market yield of TIPS was > 3%. The TIPS market rate was around -1% in 2020 and 2021. Now it’s almost zero.

The real yields of Treasuries have been negative for a while but in the range of 0% to negative 1%, not as low as the TIPS. The historic real yield of the 10YT was about 2% but the Fed suppressed it to negative in 2020-22. It’s recently been slightly positive.……

The market currently thinks the 5 year inflation rate will be 2.55% and the 10 year inflation rate 3%. This could turn out to be right or wrong. Only time will tell.

The Fed has said that they want the Fed funds rate (and presumably longer term Treasuries as well) to be “neutral” to avoid stimulating inflation. Negative real yields stimulate inflation so yields have a long way to rise. This will have a huge impact on all the asset markets.……

**Real Yields Wade Toward Positive Territory, Denting Stocks**
**The rise of inflation-adjusted bond yields has hit some of Wall Street’s more speculative bets**
**By Julia-Ambra Verlaine, The Wall Street Journal, April 26, 2022**

**Yields on government bonds are catching up with expected inflation after years of lagging behind it, a threat to the speculative stock-market bets that proliferated in the era of rock-bottom rates and economic stimulus....**

**Interest-rate derivatives show that investors expect the Fed to increase its benchmark rate from its current level between 0.25% and 0.5% to just above 3% next year. ...**

**Rising rates increase corporate borrowing costs and offer investors an alternative means of earning decent returns, which can hurt stocks generally. But the effect tends to be larger on so-called growth stocks, because investors deem uncertain future profits less valuable when they can get more guaranteed income from Treasurys....** [end quote]

If the benchmark fed funds rate rises to 3% (nominal) and the Fed stops buying (and may soon start selling) longer term bonds, the 10 year Treasury real yield may rise from negative toward its historic real yield of 2%. Depending on inflation, that could be a nominal yield of 12%, if inflation stays at the current level of almost 10%. That is an immense change that will disrupt all the asset markets (stocks, bonds, real estate).

I think that interest rates will continue rising. The stock market knows that, but is guaranteed to have a hissy fit when it happens in reality (not just Fed jawboning).

This is the biggest Macro trend change since Covid-19 hit in March 2020. Those who plan to hold stocks (especially speculative tech stocks) through the predictable decline should remember what happened after the bubble burst in 2000.