Negative real rates of return

Inflation-protected securities sold at negative yields for the first time ever on Monday as traders anticipate that the Federal Reserve will start a new round of asset purchases.

There are liquidity issues, hedging issues, reinvestment risk issues, supply-side finance management issues, and so on.  This does not show that our real economy has a negative real rate of return.  Maybe, for reasons of institutional constraint, people buy these securities as an inflation hedge rather than investing in the real economy.  Still…

There is more here.

Question: When the measured expected real return is below zero, how well can any recovery program work?  


Well, isn't that the signal to those with money to invest their money in replacing red listed bridges n the areas they travel for their own safety and that of their community?

The huge amounts of cash sloshing around are in large part the result of cutting taxes to put money in the pockets of individuals who will invest it more wisely than government?

Clearly paying taxes to replace bridges likely to fail is not a wise government investment, but for those who die or their families, individuals, investing in safe bridges is a wise investment.

Ditto for electric power transmission lines, for rerouting rail lines to avoid the conflict between road and rail traffic, upgrading rail lines to support high speed freight as part of removing conflicts with road traffic to compete with air freight, etc.

Many projects seem way to big for individuals alone or collectively because the private investment time horizon to deliver profit is too short. When has a private investment of tens of billions of dollars for projects that won't produce revenue for two decades been undertaken?

Clearly many investment opportunities exist, but the risks are too high because the time to profit is a generation or two.

The past few decades investment has focused on investments that have quick returns and profits: debt to fund current consumption, for example, or building houses that are so large they are liabilities instead of assets.

Buying US Treasuries is funding consumption so taxes can be cut to increase the cash flow to buy US Treasuries....

From an engineering standpoint, I find all of this action really hard to grasp. The Fed has its hands on to many knobs; it's impossible to control for any independent variable. The increase in issuance of TIPS at the same time the Fed is considering more QE is a good example. Rather than issuing more TIPS and doing more QE, why not simply start notching rates up holding the mix steady without more QE?

In general, I get a queasy feeling watching the feeding frenzy. We've seen this all before, and not even long enough ago for memories to have faded.

Positions data reported to the Federal Reserve Bank of New York by the primary dealers show that the dealers’ aggregate holdings of TIPS averaged $2.2 billion over the March 2, 2005 to March 26, 2008 period (aperiod closely corresponding to the paper’s sample period), and ranged from -$3.2 billion to
$8.1 billion. In contrast, nominal Treasury note and bond holdings averaged -$125.6 billion over this period, and ranged from -$178.6 billion to -$65.1 billion.5 Mutual funds also provide detailed reports of their holdings, including their holdings of TIPS, but such information is widely dispersed.6

The liquidity difference is not small! I wouldn't jump to the conclusion that real returns are negative right now.

You need to take into account the terms of the TIPS when drawing conclusions about expected real rates of return. Taking these terms into account, a negative TIPS yield does *not* necessarily mean a negative real rate of return.

The crucial thing to remember is that the principal amount of TIPS is increased when inflation is positive, but the principal amount of TIPS is *not* decreased when there is deflation. As an example, if I own TIPS and there is a 10 percent deflation, I earn a 10 percent real rate of return on my TIPS holdings because the principal amount on the TIPS stays constant, but the real value of that principal rises by 10 percent.

Thus, negative yield could be signaling a high probability of deflation. This means that you cannot conclude that a negative TIPS yield implies a negative real rate of return. If the expected change in the price level is -2 percent, and the TIPS yield is -.5 percent, the expected real rate of return is 1.5 percent.

But an expected deflation should affect nominal yields too. If the real rate of return is 1.5 percent, given an expected change in the price level of -2 percent, nominal bonds should be yielding -.5 percent too.

Right now, TIPS in the 2 year maturity range are yielding about -.85 percent. Nominal 2 year yields are about +.35 percent. TIPS in the 5 year maturity range are yielding about -.3 percent, whereas 5 year nominal yields are about 1 percent.

The features of TIPS can result in negative TIPS yields and positive nominal yields when there is *uncertainty* about inflation. TIPS have an option-like nature. TIPS investors are protected against inflation when the price level goes up, but can benefit from deflation. In contrast to this asymmetry, nominal bond investors are hurt by inflation and helped by deflation in a symmetric way. That is, a TIPS is like a nominal bond plus a call option on inflation struck at zero.

There's another way to look at this. In real terms, the payoff to the TIPS is its yield minus min[price level change,0]. The payoff (in real terms) to the nominal bond is its yield minus (price level change). The "min" expression in the TIPS payoff and its absence in the nominal bond payoff means, again, that the TIPS embeds an option.

This embedded option reduces the TIPS yield relative to the nominal yield. If the expected inflation rate is zero, then the nominal yield equals the real return. But the TIPS yield must be below the real rate of return to compensate for the value of the embedded option. The more uncertainty about price level changes, the more valuable is this option, and the more depressed is the TIPS yield. The difference between the nominal and TIPS yield is basically the time value (or the "extrinsic" value) of the price level change option. This time value is greater, the more volatile the inflation rate.

So right now, where a zero expected inflation rate is not an unreasonable assumption, the yield on nominal Treasuries is a more reliable estimate of the real rate of return. I would interpret the present situation as being: (a) low but positive real rates; (b) approximately zero expected inflation; but (c) substantial uncertainty about the future change in the price level. This substantial uncertainty is understandable, given the unprecedented nature of the current economic situation, and the equally unprecedented nature of monetary policy.

Professor Pirrong's comment makes perfect sense to me. The nominal negative yield is a small price to pay for the hedge against deflation.

On the other hand, if investors are hedging againse deflation, then Professor Cowen's final comment seems telling, too.

"public goods(infrastructure, education, health, etc.)": but most health and education expenditure has nothing to do with Public Goods.

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