As interest rates start to increase after many years at historically low levels, the pressing questions are how high will rates go this cycle and when exactly will these higher levels occur? While predicting when rates will get to some higher or lower level is difficult at best, expecting rates to increase to at least a historically “real rate” is a more realistic approach. Typically, investors look at the current 10-year Treasury note as the benchmark of intermediate maturity taxable interest rates. Determining the “real rate” on bond yields is computed by using the Core CPI number, which is the consumer price index less the more volatile food and energy prices as determined by the Bureau of Labor Statistics.
10-Year U.S. Treasury Yield vs CPI Ex Food & Energy
As the above chart indicates, over the last 25 years the average rate on the 10-year benchmark Treasury note was 4.20%. Over the same period of time, Core CPI (defined above) averaged 2.16%. The difference, on average, was just over 200 basis points, specifically 2.04%. As of this writing, the 10-year Treasury note yields 2.95% compared with current Core CPI, which stands at 2.10%. This gives us a “real rate” (gross yield less Core CPI) of 0.85%, well below the 25 year average of 2.08%. We believe it is unlikely that we will return to the historical average “real rate” anytime soon, even though higher rates are likely in the coming months and years.
If “real rates” stay close to current levels, the likely 100+ basis points of FED rate increases are likely to increase longer rates by at least 50-75 basis points. A flatter yield curve (short-term rates at similar levels to longer-term rates) is likely unless inflation were to increase significantly. We believe the likelihood of significantly higher inflation in the next few years is rather low given anticipated further productivity enhancements.
We therefore conclude that a normalized “real rate” occurring in the next few years is unlikely unless inflation were to increase significantly. Barring that development, we expect a relatively flat yield curve (even flatter than today) to be the norm over the next few years. When and if we have meaningful economic weakness will determine when short-term rates fall again and the yield curve should then return to a more traditional shape (short rates yielding less than intermediate or longer-term rates).