Friday, December 14, 2012

How Long Can Real Interest Rates Remain Negative?

Ray Dalio made some news this week when he acknowledged that interest rates had probably gone about as low as they could possibly go and that the next big opportunity will be shorting the bond market.  I'm inclined to agree, but there is some historical precedent for rates to go lower and stay there for even longer.

Dalio argued that real rates are currently negative (nominal rate minus inflation)--which they are--but they were also negative for 10 years between 1936 and 1946 as shown by the chart below, which compares Moody's average Aaa bond yield to the realized 10 year forward inflation rate.  Inflation was high during this period, reaching above 10% in some years thanks to WWII.  The fact that rates stayed low is a testament to the fact that it's not a good decision to try to fight the Fed.

Real Interest Rates Negative World War II
Used Aaa bonds as proxy for risk free rate.  Source: Federal Reserve Data

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