Monday 29 April 2013 by FIIG Research Legacy

How inflation can erode real return in a low rate environment

Please note that the figures mentioned in this article are no longer available.


Erosion has a connotation of inevitability, or that something is unavoidable. In many ways the erosion of nominal interest rate spread above US inflation or the erosion of “real” interest rates, has had that exact meaning; it is both inevitable and unavoidable.

In this piece we explain why this is the case.

Specifically, investors in the US with nominal bonds have return streams that effectively resemble sand on a beach where the ravages of nature or in this case the central bank can, ‘like a hurricane’ completely wipe out real investor real return. However using ILBs one can protect against the whims of the central bank who can depress real yields, thereby hijacking your return for the sake of benefiting the broader community.

As we review the inflation reading today, the prospect of short term RBA cash rates settling for some time around the medium term level of the Australian CPI will become more apparent. We argue that this is no ephemeral situation; about to “whisked-away” by a reversion to the “old days” where a 5% cash rate was the “norm”. Rather, we anticipate rates will be lower for longer; a situation that will begin to look more and more, like the current situation in the US, where long rates are now being forced down by the central bank under a program of quantitative easing (QE). By looking at the US experience therefore, an investor can get some sense of how to prepare for a low rate environment. In elaborating this argument this piece will look at the following three main topics:

  • Part one looks at a simulation of US corporate yields and how a 4% real return provides an effective solution to the challenges of quantitative easing (QE) in the United States. Here we note how investors are suffering from very low, or negative real rates, and that situation is unlikely to change,
  • Part two looks at what the future prospects for how quantitative easing (QE) might be in the short to medium term, and
  • Part three looks at the forthcoming situation in Australia and how the CPI and the RBA cash rate should settle about equal over the next few years.

Part 1: Simulation of US corporate rates

US corporate rates can be estimated by referring to the bank funding curve, which is given by what is known as the “swap” rate for two parts of the US curve; the 2 year and the 10 year. In order to make this comparison somewhat more realistic, we added 1% over this rate as this is where most of the Australian credits trade; some higher and some lower. Using this estimate of corporate 10 year fixed yields we can construct a time series and compare it to the annual CPI for the US, as we do in Figure 1 below which looks at the 10 year corporate only.

Figure 1

Of note in Figure 1 is the constant erosion of spread, or interest rate differential, between both the 10 yr. corporate bond and the CPI. There is a good reason for this compression and it centres around the policy of the Federal Reserve where interest rates have been set at roughly zero in the shorter end of the US curve and now the long end of the nominal interest rate curve is being forced lower by quantitative easing (QE). While the idea of QE has much merit for the economy as a whole, namely to stimulate growth through the provision of lower long rates, someone bears the cost of that stimulation. In many ways it is the poor old investor who bears those costs since investors in longer bonds receive less and less, relative to CPI, as Figure 1 shows.

Such a problem, as exists with nominal bonds, can be largely avoided using ILBs since the ILB is linked to inflation and the earnings level are linked to variations in inflation not the impact of the central bank on long term yields. If we add the current 4% real that is available on some selected Australian credit ILBs to US inflation, and then deduct the yield of the 2 and 10 year corporate, we can see how much the corporate ILB beats the nominal bond; both long and short, in Figure2.

Figure 2

For a brief period during mid 2009, the ILB underperformed in the longer end as deflation occurred in the US. However, in the absence of deflation, with persistent inflation of around 2% as we expect to be the case for the next few years, the ILB remains a routine out-performer by effectively preventing erosion of “real” spread. Such erosion arises in situations of low nominal rates and persistent inflation, as we currently are seeing in the US.

Part 2: QE going nowhere fast

If you think that QE is going away soon, as the frustrated, non-voting, hawks in the US Federal Reserve would have you believe, then think again. Recently, William Dudley, a very senior Federal Reserve official opened up the prospect of even increasing, or “dialling up” QE,

At some point, I expect that I will see sufficient evidence of improved economic momentum to lead me to favor gradually dialing back the pace of asset purchases. Of course, any subsequent bad news could lead me to favor dialing them back up again. As Chairman Bernanke said in his press conference following the March FOMC meeting "when we see that the…situation has changed in a meaningful way, then we may well adjust the pace of purchases in order to keep the level of accommodation consistent with the outlook." [emphasis added] (The Outlook for the National and Local Economy, April 16, 2013, Printer version, William C. Dudley, President and Chief Executive Officer).

The reason Dudley is thinking this way, is that the recent cuts in Federal spending will lead to significant “fiscal drag” on the economy, as Dudley indicated,

So why isn't the U.S. economy growing more quickly? The most important reason is the sharp shift in federal fiscal policy from mild restraint in 2012 to much greater restraint in 2013. The increase in payroll tax rates, the rise in high income tax rates, the increase in taxes associated with the Affordable Care Act, and the sequester will result in fiscal drag of about 1¾ percentage points of GDP in 2013, an unusually large amount of fiscal restraint when the economy doesn’t have strong forward momentum and unemployment is still elevated [emphasis added] (The Outlook for the National and Local Economy, April 16, 2013, Printer version, William C. Dudley, President and Chief Executive Officer).

While most are frothing at the mouth about the labour market and the growth in the housing market, Dudley indicates that the recent pick-up is “moderate” because of the fiscal drag that is already in the system, and this “drag” is about to hit US growth,

In terms of the labor market, we have seen only a moderate improvement in labor market conditions over the past six months or so. After an encouraging pick up in the pace of job creation around the turn of the year, the employment report for March showed a gain of only 88,000 jobs. While I don’t want to read too much into a single month’s data, this underscores the need to wait and see how the economy develops before declaring victory prematurely. I’d note that we saw similar slowdowns in job creation in 2011 and 2012 after pickups in the job creation rate and this, along with the large amount of fiscal restraint hitting the economy now, makes me more cautious [emphasis added] (The Outlook for the National and Local Economy, April 16, 2013, Printer version, William C. Dudley, President and Chief Executive Officer).

All this suggests that the situation faced by the US investor is precarious, especially if they are reliant on fixed rate investing for funding liabilities, or debts, that are linked to inflation. This is primarily because the fixed rate yield, as forced down by QE, is just not enough to meet the persistent demands of inflation.

Part 3: Australian situation

As we witness the Australian CPI released today you may now be wondering,

“What has the US situation got to do with the Australian situation?”

In answering this question, one needs to refer to the forecast RBA cash rate and the CPI, as shown in Figure 3 below.

Figure 3

With global growth recovering, yet slowly, and with cash rates forecast to stabilise at historic lows, the situation in Australia, while not mirroring the US situation, resembles it in many ways. Low nominal rates, as seen in the US will start to be seen, more and more, in Australia as the cash rate stabilises at very low levels. Ten year government bonds will, in this situation, tend to trade quite close to the cash rate although variations will occur and 10 year corporate will trade at about 150 bps over the ten year bond, meaning corporate rates will approach 4%, assuming a stable cash rate of 2.5%. While a nominal rate of 4% is “great”, when comparing to the available corporate rates in other developed economies, it is not “great” when compared to inflation, if inflation stabilises around 2.50%.

By way of comparison, 4% above inflation as provided by corporate ILBs, will be very hard to obtain in such an environment, as rates will be low and inflation will erode the value of any spread that is available in the Australian nominal bond market. While 4% above inflation remains available at this point, before RBA cash rates settle at lower levels, as the RBA tries to stimulate the non-mining sector of the Australian economy, we anticipate that the presence of 4% real ILB yields will be eliminated within a lower yield environment; one that resembles the situation in the US.

In addition there is always the risk that Australia more fully mirrors the situation in the US, if growth continues to be weak in the non-mining sector. If that happens then longer rates will move even lower relative to CPI so that the compression of real yields will accelerate.


As the Australian CPI is released the prospect of RBA cash rates settling around the medium term rate of inflation (of 2.5%) seems to be developing, which means longer nominal rates are headed lower. A struggling global economy, a weakening mining sector and a conservative consumer are making the recovery in the non-mining sector difficult, and should keep the cash rate stable and very low for some time. All these low short cash rates are depressing long term bond yields and the US provides a guide on what happens to real rates when nominal rates are forced lower by QE in an environment where inflation is persistent; a situation that is not going away anytime soon. When rates are low for a long time, the longer end of the bond market effectively fails to keep pace with inflation.

A better way to invest therefore is to look more closely at inflation linked bonds; bonds that lock one into changes in the rate of inflation. Otherwise, you need to trust that a central bank will not sacrifice your return, by depressing nominal rates, so as help stimulate growth. This is what has, what is, and what will be, the case in the US for some time. Investors are suffering with low rates in the US relative to the CPI (so as to push growth forward), and simulations contained herein show how a 4% real rate would have avoided most of this pain. By linking returns to the CPI investors can avoid the direct impact of official institutions on bond pricing, and insure that returns beat the primary investment target for most investors; the CPI plus a margin. By beating the CPI, one protects purchasing power and the ability of the consumer to fund retirement liabilities, thereby avoiding the erosion to real return that has already occurred in the US and which should also occur in the Australian market, over time.

With bonds like Sydney Airport available above 4% real, one has the chance of avoiding what has become the norm in the US; low or negative returns, relative to the CPI. As RBA cash rates fall in Australia, that chance is diminishing every-day, as real yields collapse, so investors should consider looking at ILBs sooner, rather than later.