Link Between Inflation And Risk-Free Rate

Link Between Inflation And Risk-Free Rate

In 2022, 𝐢𝐧𝐟𝐥𝐚𝐭𝐢𝐨𝐧 would be the single most significant risk for global growth.

To substantiate my above argument, I looked at 𝐈𝐌𝐅 𝐞𝐜𝐨𝐧𝐨𝐦𝐢𝐜 𝐨𝐮𝐭𝐥𝐨𝐨𝐤 𝐝𝐚𝐭𝐚 to get the real GDP growth and expected inflation for the US from 1980 to 2021. The reason to choose the US was that with the increase in globalization, any changes in Fed rates impact other economies, especially emerging economies.

Then i took the 𝐅𝐢𝐬𝐡𝐞𝐫 𝐞𝐪𝐮𝐚𝐭𝐢𝐨𝐧 that explains the relationship between real interest and nominal interest rate.

I assume that the real interest rate reflects the real GDP, and the nominal interest rate reflects the inherent risk-free rate.

𝐑𝐢𝐬𝐤 𝐟𝐫𝐞𝐞 𝐫𝐚𝐭𝐞 = 𝐑𝐞𝐚𝐥 𝐆𝐃𝐏 𝐠𝐫𝐨𝐰𝐭𝐡 + 𝐄𝐱𝐩𝐞𝐜𝐭𝐞𝐝 𝐈𝐧𝐟𝐥𝐚𝐭𝐢𝐨𝐧

Then, i compared this risk-free rate with ten year US treasury bond.

We generally take the ten-year treasury bond as the risk-free rate in valuation.

𝐅𝐨𝐥𝐥𝐨𝐰𝐢𝐧𝐠 𝐚𝐫𝐞 𝐦𝐲 𝐨𝐛𝐬𝐞𝐫𝐯𝐚𝐭𝐢𝐨𝐧𝐬 𝐥𝐨𝐨𝐤𝐢𝐧𝐠 𝐚𝐭 𝐭𝐡𝐞 𝐈𝐌𝐅 𝐝𝐚𝐭𝐚:
•From 1980 to 2021, the difference between the risk-free rate and 10 yr treasury bonds is -0.17%, indicating that the fed rate and risk-free almost move in the same direction.

•However, the differences increased in 𝟭𝟵𝟴𝟮-𝟭𝟵𝟴𝟯, 𝟭𝟵𝟵𝟭, 𝟮𝟬𝟬𝟵, 𝗮𝗻𝗱 𝟮𝟬𝟮𝟬-𝟮𝟬𝟮𝟭. These were the 𝒓𝒆𝒄𝒆𝒔𝒔𝒊𝒐𝒏 𝒚𝒆𝒂𝒓𝒔.

•Every time there is a recession, the ten-year T-bond rate decreases. Further, as the real GDP growth decreases, the Fed resorts to 𝒒𝒖𝒂𝒏𝒕𝒊𝒕𝒂𝒕𝒊𝒗𝒆 𝒆𝒂𝒔𝒊𝒏𝒈 to improve liquidity.

•In 2021, the inflation rose to 4.3%, but 10 yr T-bond remains at 1.51%, which means that i invest in an asset that does not protect me against inflation. Thus, investors gravitated towards riskier assets, especially equities.

•With access to cheap capital, VC/PE firms leveraged this situation to provide money to startups, 𝙡𝙚𝙖𝙙𝙞𝙣𝙜 𝙩𝙤 𝙩𝙝𝙚 𝙚𝙢𝙚𝙧𝙜𝙚𝙣𝙘𝙚 𝙤𝙛 𝙪𝙣𝙞𝙘𝙤𝙧𝙣𝙨.

𝐈 𝐬𝐮𝐦𝐦𝐚𝐫𝐢𝐳𝐞 𝐭𝐡𝐞 𝐟𝐨𝐥𝐥𝐨𝐰𝐢𝐧𝐠:
•The T-bond rate has to increase momentarily to adjust to rising inflation.

•Then, for T-Bond rates to go back to 2019, either inflation has to reduce or growth has to dip.

•If the T-Bond rate increases, the risk capital will move from riskier assets like equities/crypto to tangible assets like real estate and bonds.

•If the T-Bond rate does not increase, the risk capital will increase to high-risk equity assets like small-cap firms or crypto. In addition, investors will gravitate toward gold to hedge high inflation risk.