Understanding Real Interest Rates and Their Impact on the Stock Market

For around a decade now, some investors have been worried about inflation. There was an understandable feeling that a decade of loose monetary policy with the Fed printing money by simply creating credits in the accounts of banks when it bought bonds from them, that it had to devalue the dollar in terms of its buying power. Until now, though, that fear has proven to be unfounded. The massive amount of slack in the economy that is created by a credit crisis has allowed the U.S. to absorb all that loose money, with inflation staying generally below the Fed’s 2% target rate.

This year, that has changed. Inflation is here, but the dire warnings of the inflation bears still haven’t come true. The major indices are nudging record highs, even as inflation takes hold. If you find yourself asking how that can be, consider the effects of "real interest rates."

That is a phrase that you will have heard bandied about a lot by some commentators. Bloomberg’s morning host Tom Keene is particularly fond of using it, for example, to the point where his co-hosts gently poke fun at him for it. Most of us understand the basic idea of real interest rates, but very few bother to think through the implications of them in a market where interest rates and prices of both consumer goods and stocks are increasingly disconnected. And what, exactly, is the "real interest rate"?

The real interest rate for a bond investor is the return they get after taking inflation into account.

We invest to make money in an attempt to increase our wealth, but often forget that the value of money itself is not fixed. Dollars have value only as a way of paying for other things, and if prices go up, each dollar buys less, and is therefore “worth” less in real terms. Let’s say you invest with the aim of buying something specific, a house or a car, for example, in a year’s time. If your investment earns 5% in that year but the price of the house or car goes up by 10%, you would be further away from making the purchase than when you started. You would have effectively lost money on your investment, despite a 5% "gain."

That is the situation that bond investors in the current environment find themselves in every day. Even so-called "core" inflation, which takes out volatile things like food and energy, is currently running at 4%, according to the official data, with the more relevant-to-consumers CPI jumping 5.4% over the last year. During that year, the yield on the 10-Year T-Note has been somewhere between 0.75 and 1.75 percent, meaning that if you bought the -Year at any time, you lost money on your investment in real terms.

I mention this, not to elicit sympathy for the big funds and financial companies that buy the bulk of U.S. government bonds, but because it has a huge impact on what we, the average investor, can expect from the stock market. The relative attractiveness of stocks and bonds decides how much support each market receives and, as we have seen around the world over the last decade or so, low interest rates don’t necessarily make bonds unattractive. If inflation is running at 1%, a 1.5% yield looks pretty good. However, if inflation is at 4%, stocks look much more attractive on a relative basis.

There is more risk in equities by their very nature, but if the alternative is to lock in a guaranteed loss in real terms, the relative risk is reduced substantially.

That is where we are right now. The Fed has decided that the current inflation is "transitory," and they control rates, at least those in shorter-term markets. So, we are in the unusual position of low and even falling interest rates at a time when inflation is rising. Only time will tell whether that policy is wise or foolish, but for now it means that real interest rates for bond investors are negative, which in turn means that inflation, far from being bad for stocks as we have been told it would be, actually lends support to the market.

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