Negative Real T-Bill Rates

Tom Beilstein, Portfolio Manager

One recent development that should prove positive for the stock market is that real short-term rates have turned negative. A real interest rate is defined as the yield on a bond minus inflation. As of the end of May, the yield on T-Bills was 1.09%, while the current inflation rate as measured by CPI was 2.06%. This gives investors in T-Bills a real return of (0.97%). This is a bullish sign for equities for two reasons.

First, it makes cash and short-term investments an unappealing alternative. Every investor that makes an investment in a T-bill or money market is losing purchasing power every day. In order to maintain the ability to buy the same number of goods and services with your money, your investment must earn a rate of return at least equal to the inflation rate. There is currently over $1.8 billion in money market funds, much of which will need to find an investment with higher potential returns

Secondly, a negative real return on T-bills suggests that the Federal Reserve is willing to allow reflationary pressures to beat back deflationary forces. In the case of reflation, the market can maintain its expectation that low rates and abundant liquidity will lift the economy and corporate earnings, both of which are positive for the stock market. Deflation, on the other hand, would render high liquidity insignificant and send real rates back to positive levels. This would discourage borrowing and cut off the expansion.

Historically, low real rates have been positive for the stock market. When real t-bill yields have been 0.4% and below, the stock market has outperformed long-term bonds by an average of 7.1% per year. This scenario has also been very positive for small-cap stocks. Small-caps have outperformed large-caps by an average of 14.5% per year when real t-bill yields are below 0.4%. This is consistent with the fact that small-caps tend to outperform when credit spreads are contracting and when the economic outlook is improving.

So as long as real short-term yields are negative, investors will need to look elsewhere for positive real returns. Looking back, the stock market has been a favorite alternative in times like these

Source: Ned Davis Research