One possible explanation is an expectation of massive deflation (perhaps due to AI-caused decreases in production costs) which the structure of Treasury Inflation Protected Securities (TIPS) and other inflation-linked government bonds — the source of your real interest rate data — doesn’t account for.
While TIPS adjust the principal (and corresponding coupons) up and down over time according to changes in the consumer price index, you ALWAYS get at least the initial principal back at maturity. Typical “yield” calculations, however, are based on the assumption that you get your inflation-adjusted principal back (which you do if inflation was positive over its term, as it usually would be historically).
This means that iff there’s net deflation over its term, the “yield” underestimates your real rate of return with TIPS by the amount of that deflation.
1. Very interesting, thanks, I think this is the first or second most interesting comment we’ve gotten.
2. I see that you are suggesting this as a possibility, rather than a likelihood, but I’ll note at least for other readers that—I would bet against this occurring, given central banks’ somewhat successful record at maintaining stable inflation and desire to avoid deflation. But it’s possible!
3. Also, I don’t know if inflation-linked bonds in the other countries we sample—UK/Canada/Australia—have the deflation floor. Maybe they avoid this issue.
4. Long-term inflation swaps (or better yet, options) could test this hypothesis! i.e. by showing the market’s expectation of future inflation (or the full [risk-neutral] distribution, with options).
One possible explanation is an expectation of massive deflation (perhaps due to AI-caused decreases in production costs) which the structure of Treasury Inflation Protected Securities (TIPS) and other inflation-linked government bonds — the source of your real interest rate data — doesn’t account for.
While TIPS adjust the principal (and corresponding coupons) up and down over time according to changes in the consumer price index, you ALWAYS get at least the initial principal back at maturity. Typical “yield” calculations, however, are based on the assumption that you get your inflation-adjusted principal back (which you do if inflation was positive over its term, as it usually would be historically).
This means that iff there’s net deflation over its term, the “yield” underestimates your real rate of return with TIPS by the amount of that deflation.
1. Very interesting, thanks, I think this is the first or second most interesting comment we’ve gotten.
2. I see that you are suggesting this as a possibility, rather than a likelihood, but I’ll note at least for other readers that—I would bet against this occurring, given central banks’ somewhat successful record at maintaining stable inflation and desire to avoid deflation. But it’s possible!
3. Also, I don’t know if inflation-linked bonds in the other countries we sample—UK/Canada/Australia—have the deflation floor. Maybe they avoid this issue.
4. Long-term inflation swaps (or better yet, options) could test this hypothesis! i.e. by showing the market’s expectation of future inflation (or the full [risk-neutral] distribution, with options).
It appears the UK’s index-linked gilts, at least, don’t have this structural issue.
See “redemption payments” on page 6 of this document, or put in a sufficiently large negative inflation assumption here.