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I'm having hard time understanding what is causing the trend below:

enter image description here

In theory, since it is inflation adjusted I'd expect the yield to fluctuate with the economic cycle, but not systematically drift in a particular direction. What's going on here, and what does it mean for an average investor?

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Keep in mind there are a couple of points to ponder here:

  1. Rates are really low. With rates being so low, unless there is deflation, it is pretty easy to see even moderate inflation of 1-2% being enough to eat the yield completely which would be why the returns are negative.

  2. Inflation is still relatively contained. With inflation low, there is no reason for the central banks to raise rates which would give new bonds a better rate. Thus, this changes in CPI are still in the range where central banks want to be stimulative with their policy which means rates are low which if lower than inflation rates would give a negative real return which would be seen as a way to trigger more spending since putting the money into treasury debt will lose money to inflation in terms of purchasing power.

A good question to ponder is has this happened before in the history of the world and what could we learn from that point in time. The idea for investors would be to find alternative holdings for their cash and bonds if they want to beat inflation though there are some inflation-indexed bonds that aren't likely appearing in the chart that could also be something to add to the picture here.

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On a longer time scale, the plot thickens:

enter image description here

It almost looks random. A large drop in real rates in the mid-70s, a massive spike in the early 80s, followed by a slow multi-decade decline.

The chaos doesn't seem to be due to interest rates. They steadily climbed and steadily fell:

enter image description here

All that's left is inflation:

enter image description here

First, real rates should be expected to pay a moderate rate, so nominal rates will usually be higher than inflation.

However, interest rates are very stable over long time periods while inflation is not. Economists call this type of phenomenon "sticky pricing", where the price, interest rates in this case, do not change much despite the realities surrounding them.

But the story is a little more complicated.

In the early 1970s, Nixon had an election to win and tried to lessen the impacts of recession by increasing gov't spending, not raising taxes, and financing through the central bank, causing inflation. The strategy failed, but he was reelected anyways.

This set the precedent for the hyperinflation of the 1970s that ended abruptly by Reagan at the beginning of his first term in the early 1980s. Again, interest rates remained sticky, so real rates spiked.

Now, the world is not growing, almost stagnating. Demand for equity is somewhat above average, but because corporate income is decelerating, and the developed world's population is aging, demand for investment income is skyrocketing.

As demand rises, so does the price, which for an investor is a form of inverse of the interest rate.

Future demand is probably best answered by forecasters, and the monetarist over and undertones still dominating the Federal Reserve show that they have finally learned after 100 years that inflation is best kept "low and stable":

enter image description here

But what happens if growth in the US suddenly spikes, inflation rises, and the Federal Reserve must sell all of the long term assets it has bet so heavily on quickly while interest rates rise? Inflation may not be intended, but it is not impossible.

  • Thanks for the detailed answer. I think this sentence gave me a really good idea: "As demand rises, so does the price, which for an investor is a form of inverse of the interest rate." – Enno Shioji Jun 21 '14 at 8:01
  • @EnnoShioji Anytime! – user11865 Jun 21 '14 at 21:59

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