In many countries there’s a limited history of real rates. To work out their past level you need nominal interest rates and a history of inflation expectations. The path tracked by nominal interest rates is easy to find but measuring inflation expectations over time is tricky.
Fortunately, in the UK there’s a readily available thirty-year history of real interest rate data in the form of the FTSE Actuaries UK Index-Linked index series. This series includes both price and yield data for the UK Government’s index-linked gilt market, one of the oldest inflation-linked debt markets in the world.
The market for US inflation-linked government bonds, called Treasury Inflation-Protected Securities (TIPS), is younger, having started in 1997. Many other governments now issue inflation-linked bonds, including those in Australia, France, Italy, Germany, Canada, Japan, Mexico, Turkey, Brazil, South Africa, Spain, Sweden, Greece and Israel.
In the chart we show the real yield on the FTSE Actuaries UK Index-Linked All Stocks index, which includes all index-linked gilts in issue, over the last ten years. The real yield calculation is based upon a 3% inflation assumption.1
It’s one FTSE benchmark that enables investors to monitor a key indicator of global financial health.
Real Yield of FTSE Actuaries UK Index-Linked All Stocks Index
Source: FTSE, data as at 17 March 204 to 16 December 2014. Past performance is no guarantee of future results.
Since 2011, the real yield on the index-linked bond market as a whole has been negative and the indicator as yet shows no sign of turning up.
Here is a chart of 10-year US TIPS yields since 2004. Since the financial crisis, US inflation-linked bonds have also seen their real returns dip into negative territory.
Real Yield on Constant Maturity 10-Year TIPS
Source: St. Louis Fed, data from 2 January 2004 to 18 December 2014. Past performance is no guarantee of future results.
Even though falling real rates may boost asset prices, they don’t please everyone. For a start, negative real yields mean savers are failing to receive a positive post-inflation return on their cash, at least if lent to the government. If you buy an index-linked gilt with a real yield of -1% a year and hold it to maturity, you are locking in an annual return of inflation minus 1% over the life of the bond.
Many observers link negative real rates to recent central bank policy in the form of near-zero official interest rates and programmes of quantitative easing (QE).
“Long-term asset purchases may have compressed real term premiums on long-term government bonds in the United States and United Kingdom. A reduction in the real term premium, in turn, may explain part of the increase in the equity premium,” the IMF observed in its April 2014 World Economic Outlook.2
In its Outlook, the IMF links the steady decline in real interest rates to longer-term trends: to the substantial increase in saving in emerging economies, to portfolio shifts from equities to bonds and to a decline in the investment rate in developed economies.
The IMF is cautious about the prospects for a sharp rise in real interest rates.
“No compelling reasons suggest a return to the average level observed during the mid-2000s (that is, about 2 percent),” the IMF wrote in the report.
Real interest rates may not be a glamorous indicator, but they are important. Given its recent decline to historic lows, the real yield on the UK’s index-linked government bond market may be a benchmark to watch in 2015.
 Because of a technicality in the way inflation-linked bonds work, you need an inflation assumption to calculate real yields. FTSE also calculates real yields based on 0%, 5% and 10% inflation assumptions.
© 2015 London Stock Exchange Group companies.
London Stock Exchange Group companies includes FTSE International Limited (“FTSE”), Frank Russell Company (“Russell”), MTS Next Limited (“MTS”), and FTSE TMX Global Debt Capital Markets Inc (“FTSE TMX”). All rights reserved.
“FTSE®”, “Russell®”, “MTS®”, “FTSE TMX®” and “FTSE Russell” and other service marks and trademarks related to the FTSE or Russell indexes are trademarks of the London Stock Exchange Group companies and are used by FTSE, MTS, FTSE TMX and Russell under license.
All information is provided for information purposes only. Every effort is made to ensure that all information given in this publication is accurate, but no responsibility or liability can be accepted by the London Stock Exchange Group companies nor its licensors for any errors or for any loss from use of this publication.
Neither the London Stock Exchange Group companies nor any of their licensors make any claim, prediction, warranty or representation whatsoever, expressly or impliedly, either as to the results to be obtained from the use of the FTSE Russell Indexes or the fitness or suitability of the FTSE Russell Indexes for any particular purpose to which they might be put.
The London Stock Exchange Group companies do not provide investment advice and nothing in this communication should be taken as constituting financial or investment advice. The London Stock Exchange Group companies make no representation regarding the advisability of investing in any asset. A decision to invest in any such asset should not be made in reliance on any information herein. Indexes cannot be invested in directly. Inclusion of an asset in an index is not a recommendation to buy, sell or hold that asset. The general information contained in this publication should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional.
No part of this information may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without prior written permission of the London Stock Exchange Group companies. Distribution of the London Stock Exchange Group companies’ index values and the use of their indexes to create financial products require a license with FTSE, FTSE TMX, MTS and/or Russell and/or its licensors.
Past performance is no guarantee of future results. Charts and graphs are provided for illustrative purposes only. Index returns shown may not represent the results of the actual trading of investable assets. Certain returns shown may reflect back-tested performance. All performance presented prior to the index inception date is back-tested performance. Back-tested performance is not actual performance, but is hypothetical. The back-test calculations are based on the same methodology that was in effect when the index was officially launched. However, back-tested data may reflect the application of the index methodology with the benefit of hindsight, and the historic calculations of an index may change from month to month based on revisions to the underlying economic data used in the calculation of the index.