Real interest rates are ultimately what investors care about. Nominal Rates (The yields that the bond offers) minus the inflation rate is what you really are getting in a return. We peruse the world to see how the US stacks up against negative rate bonds. "Really" the US has amongst the lowest yields in the world. That's why we think we saw the dollar sell off post-Fed. This magnifies the fact that inflation is the stock market risk (NYSEARCA:SPY).
First let's simply define real rates:
Nominal Rate (The "coupon") minus Inflation = Real Interest Rate
Explanation Of Real Rates:
When I hold a bond I care about the future cash flows that I am going to receive. Ultimately I am going to use that money received in the future to buy things I need and want. Should I buy them now or should I invest my money, hopefully have more of it, and buy them in the future? That depends. What do they cost me now and what will they cost me in the future? If they are not going to cost me much more in the future I invest my money now. If they are going to cost me much more in the future maybe I don't invest that money and buy them now when those goods are still cheap.
That's the "real" idea behind real rates. All bond investors care about inflation and it's a main factor driving bond prices.
If inflation is higher I will sell those bonds to buy what I need now while goods are still cheap. That bond selling is a market function where inflation causes bond selling. At the new lower bond price and the same coupon, yield adjusts to a higher rate. That's how markets work.
That's the inflation impact
So while inflation has been low it is feared to be picking up in the US. The rest of the world is clamoring for inflation. If countries show more inflation real-rates will go down making their bonds less attractive in comparison with the rest of the world.
That's why inflation matters.
Now let's look where the US stacks up in real-rates.
We rank the below grid by real-interest rates.
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Source: Tradeconomics.com
We ranked the above chart by real rate. We take the recently reported CPI. We then take the country's 10 year yield. We subtract CPI from the 10 year yield to get real rates.
Let's see where the US stacks up.
Out of 16 of the major countries and regions in the world the US is 13th. The US real interest rate is in the bottom 20% of the globe.
We can now understand why the dollar sold off post-Fed meeting.
Because the world of investing is a competitive field, these returns matter. As soon as the Fed held off and backed off from its hawkish stance last week the dollar sold off.
The dollar sold off again on weak GDP.
Wait a minute. The Fed holding off is inflationary but weak GDP is not inflationary. It's the opposite.
We think the Fed held off BECAUSE a weak GDP and can't raise rates even if inflation goes up.
That's why we think the dollar sold off last week on BOTH events. If the Fed's hands are tied they let inflation "out of the cage." They can't do anything about it because any tightening will further slow an already very slow economy.
Here's the dollar selling off last week.
Here is the euro (NYSEARCA:FXE) versus the dollar (NYSEARCA:UUP).
Here is the dollar versus the yen (NYSEARCA:FXY).
Investors showed last week that they think the Fed is on hold and will not do anything about its globe-leading inflation rate.
US inflation is higher than most and picking up.
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Source: Tradeconomics.com
The US ranks fifth out of the major countries and regions of the world.
The US is also seeing a pickup in inflation.
Here's CPI picking up. Any higher and it's a breakout. It's already been clearly moving up.
Here's PCE that reports on Tuesday. This has also clearly been moving up after going sideways for some time.
Here are some of the major regions and countries' inflation rates in comparison. While they all generally see inflation picking up, their rates are much lower.
Here is the EU.
Eurozone inflation is picking up.
Here is China.
China is high but slowing somewhat.
Here is Japan.
Japan is seeing deflation.
Here is Germany.
German inflation is picking up fast (below). Even though this is a low annual rate you can see it's been lifting sequentially.
Here is the UK. The UK inflation is slower than the US but picking up.
The US inflation rate is higher and accelerating when compared to most major countries.
Overall you can see that among the largest nations in the world, the US has the fastest inflation rate. The US inflation rate is also picking up.
Conclusion
This is a bond and stock market risk.
Inflation is a critical pricing mechanism for bonds. Investors care about the real-interest rate. If the US inflation rate continues to tick up it's bonds will likely sell off.
We also see a worldwide phenomenon of the largest nations experiencing a pickup in inflation (except for Japan). As inflation picks up around the globe real rates, by definition, will plunge which likely get the principal amounts (bonds) to drop.
Lower bonds in this market likely means lower stocks.
That's why inflation is so important.
Please be safe.
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Disclosure: I am/we are short SPY.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
