Tuesday, May 31, 2016

Are Real Yields Too High?

With real yields seemingly so low, seems like such a silly question. Right? Well...

I posted the following chart nearly 3 years ago.

August 15, 2013
Illusion of Prosperity: The Long-Term Death of Real Yields

Click to enlarge.

The black line shows the real interest rate investors earned on the 10-year treasury from the time of purchase (we don't know what the real yield is until 10 years have elapsed). The blue line shows what the real interest rate investors earned on the 10-year TIPS (we know instantly because the rate is the real yield).

The 10-year TIPS yielded 0.57% as I posted that in 2013. It only yields 0.25% today. Most financial experts warned savers about the risk of rising real yields but few warned savers about the risk of falling real yields. For savers, the latter risk is far more terrifying. Sitting in cash? Waiting for higher real yields that never seem to come? Nightmare.

I have and continue to be believe that it will be harder and harder to make money off of money in the future. That's why I was so willing to lock in long-term real yields before they could potentially fall further. That plan has worked out exceedingly well, at least so far.

So, where do we stand now? If we extend the blue line in the chart out three years, then today's real yields are above the long-term trend. Why is that? Here is one explanation.

When the stock market has been doing well, people prefer stocks over bonds. We therefore saw higher real yields heading into the dotcom bust and we saw higher real yields heading into the housing bust. In hindsight, those were therefore particularly good times to lock in a guaranteed long-term real yield for the long-term. Are we heading into another stock market bust? Or has the past year or so been a false alarm? I would not claim to know.

What if our fragile economy actually requires real yields to fall over the long-term though? Falling real yields allow things like corporate debt and home mortgages to be refinanced with easier and easier terms. That's been going on for nearly 40 years so far. Rising real yields would do just the opposite. I don't think our economy could tolerate that.

What is our economy going to be like when, not if, this ongoing falling real yield support ends? It can't go on forever. South Park has shown us what negative real yields do in the extreme. It isn't pretty.

Is today's 0.25% real yield on the 10-year TIPS a blessing or a curse? The easiest and most reliable answer is that we will know in 10 years. Anything else is just a guess. Good luck out there. We may all need it. Sigh.

No comments: