While the real cost of debt has been declining for decades, the U.S. 10-Year Treasury inflation-protected security — or real interest rate — just hit a new all-time low today of -0.89% [Figure 1].
What does “real” mean? It’s the U.S. 10-Year Treasury rate adjusted for expected inflation, which represents the true cost of taking on debt. Because while cash flows grow at the rate of inflation, debt payments like a mortgage are fixed when you take them on.
How do low real rates influence market action?
Low real rates have been a major driver of the demand for extra spread in fixed income markets such as corporate bonds, high-yield bonds, and longer duration government bonds.
But low rates have also led to a weaker U.S. dollar (USD). In fact, the dollar index is at its lowest value since Fall of 2018 — down almost 8% from its peak in March. At the same time, gold prices have skyrocketed higher, with the spot price of gold up almost 25% on the year and currently just shy of the 2011 all-time high of $1900 per ounce.
Finally, real interest rates have also been a driver of growth stocks’ outperformance, which can be thought of as longer duration equities than value stocks. According to the commonly followed indices published by Standard and Poors, the S&P Growth Index has outperformed the S&P Value Index by about 26% year-to-date (YTD).
And what about their impact on the economy?
Rates this low mean the cost of debt is also low, which should promote investment and support future growth — but only if companies and individuals are willing to take on debt to do so. Right now, however, the outlook is so uncertain that the demand for new credit is far below the supply. That’s also partly why real rates are so low.
But if we can get more clarity on the outlook for the economy, demand for credit should increase. And because the cost of debt is so low, that should provide a tailwind to the recovery.
What do low real rates mean for financial planning?
From a planning perspective, a real interest rate this low is dreadful. Why? Because it means the yield available on benchmark fixed income assets won’t even keep up with expected inflation. So, investors who have historically relied on bonds for capital preservation and income could see their purchasing power erode over time.
What’s the implication for advisors and for retirement or distribution clients? You may need to explore the use of riskier asset classes for building income portfolios and then seek to offset the volatility of those asset classes with more conservative assets like insurance — or by using risk mitigation approaches designed to guard against loss.