In a June 1 TradeSmith Daily, we explained why, in a deflationary environment, the price of gold tends to go up. You can read that piece here.
The short version is that, when things turn deflationary, the real yield on Treasuries turns negative.
A negative real yield, meanwhile, is worse than a zero yield. If you are earning a negative amount, it is like going backward instead of forward.
In these conditions, a yield of zero is better than a yield that is negative. And thus a stable asset with a yield of zero, like gold, will outperform.
Then, too, in a deflationary environment, real yields tend to stay negative for a very long time.
The central bank makes this happen on purpose by keeping the nominal yield — the official interest rate you hear quoted in the financial press — below the rate of inflation.
The central bank does this in a deliberate attempt to inflate away the nation’s debts. When the real yield is negative, the debt is losing value over time, because inflation (what little is left of it) is eroding the value.
If a nation is drowning in debt, and can’t grow its way out, this inflationary erosion is the way out of a jam. If inflation can sufficiently erode the value of the debt, it reduces the debt burden over time.
For countries that issue debt in their own currency, negative real yields (where inflation is greater than the nominal yield) are thus a kind of soft default — a de facto means of reducing the debt burden while still making official payments.
There is an easy way to calculate real yields for yourself, in less than 60 seconds. You can do this via the free government data, in handy chart form, provided by the St. Louis Federal Reserve FRED database.
The calculation has three steps:
- Start with the 10-Year Treasury Constant Maturity Rate, also known as the nominal interest rate. (You can also use the 30-year or 5-year.) The 10-Year rate is available via FRED here.
- Subtract the Breakeven Inflation Rate for the same time period. For example, the 10-Year Breakeven Inflation Rate is available via FRED here.
- What you are left with is the “real yield,”.
- 10-Year Constant Maturity Rate for July 16: 0.62%
- 10-Year Breakeven Inflation Rate for July 16: 1.41%
- 0.62% – 1.41% = (0.79%)
So, the real yield on 10-Year Treasuries, as of this writing, is minus 79 basis points, or negative 0.79%.
This means something important. It means that inflation is eating the purchasing power of Treasuries at a faster rate than the payments can cover the loss. (That is why the value of the debt is eroding.)
Going back to our example: Imagine John Q. Investor owns $10,000 worth of 10-Year U.S. Treasuries at the current levels. John will receive a yield of $62 per year. But at the same time, inflation (as estimated by expectations) will eat up $141 per year worth of purchasing power.
The net result is a loss: Even though John has more dollars in his account than before, the total value of the position, in purchasing power terms, is worth less than it was due to inflation.
With gold, something different happens. If John Q. Investor owns, say, $10,000 worth of gold in a negative real yield environment, the price of gold is likely to go higher over the course of a year, by more than enough to make up the difference.
This is not so much because the value of gold itself changes, but more because the value of the dollars — which gold is priced in — will tend to fall.
Then, too, investors holding Treasuries with negative real yields will be inclined to dump a portion of them — because a negative yield is a loss, after all — and swap into gold as a safe haven instead.
As the U.S. economic situation gets worse, it’s possible that real yields could go more negative than they are now — possibly a lot more. This could happen in one of three ways.
The first possibility is that inflation starts to rise, but nominal interest rates stay low (in part because the central bank keeps them there). This could happen, by the way, even if inflation explodes. Imagine the nominal 10-Year yield at 4% with the 10-year inflation rate at 7%. That is a negative real yield of minus 3%.
The second possibility is that nominal bond yields go negative as the economy slows further, and central banks take ever more desperate measures to fight a deflationary downward spiral.
Due to the presence of deflation pressure, some macro investors think we could see a negative yield on the 10-Year U.S. Treasury — a nominal yield below zero — within the next year.
If the nominal yield is negative, breakeven inflation expectations could fall to zero, too (via the world in the grip of deflation) and the real yield would still be negative (because a negative yield minus zero inflation is negative).
The third possibility is that the Federal Reserve, in a last-ditch move to keep the economy from spiraling into a second Great Depression, deliberately takes the whole interest rate curve deep into negative territory as an official policy move.
In this last scenario, which is actually being advocated for by a handful of prominent economists, one could imagine the short-term Federal Funds rate at, say, negative 2%, forcing institutions to flee from cash (with a special exemption for consumer bank accounts under a certain size).
Either way, now you know how to quickly calculate the real yield.
You can simply use the St. Louis Federal Reserve FRED data — again the 10-Year Constant Maturity Rate is here and the 10-Year Breakeven Inflation Rate is here — starting with the nominal rate and subtracting the breakeven inflation rate. You can also do this with the 5-year and 30-year time frames (they are both negative now, too).