If The Fed Keeps Raising Rates, Bonds Are A Smart Buy. Here's Why.

Historically, bond prices have been boosted by high real interest rates in the U.S.

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Historically, bonds have performed better when real rates are higher than when they are lower, so bond investors can rejoice that real interest rates are at their highest in 15 years.

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As you can see from the chart below, real rates have recently turned positive — as you can see from the 10-year Treasury TMUBMUSD10Y chart, 3.729% real yield, which is double the two-decade average. For most of the past 15 years, real rates have been negative — with nominal rates being less than inflation expectations. Since late 2007, it hasn't been higher for more than a few years.

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It is possible that real rates will rise even more in the future. The Fed's Jerome Powell recently stated that more rate hikes will take place despite the fact that inflation may decline in the near future.

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Inflation expectations can justify higher nominal rates at times, so it's important to distinguish between nominal and real rates. If bond investors anticipate rates lowering and bonds rallying in that case, they are on shaky ground. However, when real rates are high, nominal rates are higher than inflation expectations—so it becomes easier to predict that nominal rates will fall and bonds will rally.

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When inflation is coming down, then nominal rates can be expected to come down as well. Now is a time when it is so crucial to distinguish nominal from real rates. Conversely, if higher inflation is here to stay, current high nominal rates will remain—or even rise.

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Expectations for inflation

The distinction suggests that it is crucial to determine inflation expectations correctly. According to the Cleveland Federal Reserve Bank’s Center for Inflation Research, the U.S. inflation rate over the next decade is expected to be 2.27%.

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This calculation relies on the Cleveland Fed's statistical model, which incorporates nominal Treasury yields, inflation data, inflation expectations surveys, and inflation swaps (derivatives whose interest rate depends on inflation). The most common alternate measure of expected inflation reaches nearly the same conclusion as this model, although it is not the only method for calculating it.

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As an alternative measure of inflation, breakeven rates are determined by comparing the yields on 10-year TIPS with the yields on the 10-year Treasury. In the last update of the Cleveland Fed's inflation estimate, the 10-year breakeven rate was 2.21% — very similar to the Cleveland Fed's estimate of 2.27%.

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Bond returns and real rates

The Cleveland Fed's expected inflation data, which extend back to the early 1980s versus the early 2000s, provided me with the data to measure the correlation between real rates and bond returns. In order to measure bond returns, I used Robert Shiller's index of bonds' inflation-adjusted total returns.

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My results are summarized below. Based on the real interest rates of all months during the past four decades, I divided them into four groups. Inflation-adjusted bond returns were higher when real rates at the start of those periods were higher, regardless of whether I focused on bond returns over the subsequent 1-year, 5-year, or 10-year periods. At the 95% confidence level, statisticians often use to determine whether a pattern is real, this pattern is significant.

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What are today's real rates like in relation to history? Even though they have risen recently, they still rank in the second-lowest quartile. Because of this, it is unrealistic to expect mouthwatering returns from the highest and lowest quartiles. Despite this, the second-lowest quartile has significant positive returns.

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How about stocks?

As far as my analysis of the past four decades is concerned, high real interest rates do not provide any useful information about the stock market. I was not able to detect a statistically significant correlation between real rates and the stock market's subsequent returns.

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While this does not necessarily state that stocks will not rally in the coming years, it does mean that we cannot draw any conclusions regarding them based on current real rates. Investors will have to settle with the good news that bonds are experiencing due to high real rates.