Link Between Inflation And Risk-Free Rate

Link Between Inflation And Risk-Free Rate

In 2022, ๐ข๐ง๐Ÿ๐ฅ๐š๐ญ๐ข๐จ๐ง would be the single most significant risk for global growth.

To substantiate my above argument, I looked at ๐ˆ๐Œ๐… ๐ž๐œ๐จ๐ง๐จ๐ฆ๐ข๐œ ๐จ๐ฎ๐ญ๐ฅ๐จ๐จ๐ค ๐๐š๐ญ๐š 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 ๐…๐ข๐ฌ๐ก๐ž๐ซ ๐ž๐ช๐ฎ๐š๐ญ๐ข๐จ๐ง 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.

๐‘๐ข๐ฌ๐ค ๐Ÿ๐ซ๐ž๐ž ๐ซ๐š๐ญ๐ž = ๐‘๐ž๐š๐ฅ ๐†๐ƒ๐ ๐ ๐ซ๐จ๐ฐ๐ญ๐ก + ๐„๐ฑ๐ฉ๐ž๐œ๐ญ๐ž๐ ๐ˆ๐ง๐Ÿ๐ฅ๐š๐ญ๐ข๐จ๐ง

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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.

๐…๐จ๐ฅ๐ฅ๐จ๐ฐ๐ข๐ง๐  ๐š๐ซ๐ž ๐ฆ๐ฒ ๐จ๐›๐ฌ๐ž๐ซ๐ฏ๐š๐ญ๐ข๐จ๐ง๐ฌ ๐ฅ๐จ๐จ๐ค๐ข๐ง๐  ๐š๐ญ ๐ญ๐ก๐ž ๐ˆ๐Œ๐… ๐๐š๐ญ๐š:
โ€ขFrom 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.

โ€ขHowever, the differences increased in ๐Ÿญ๐Ÿต๐Ÿด๐Ÿฎ-๐Ÿญ๐Ÿต๐Ÿด๐Ÿฏ, ๐Ÿญ๐Ÿต๐Ÿต๐Ÿญ, ๐Ÿฎ๐Ÿฌ๐Ÿฌ๐Ÿต, ๐—ฎ๐—ป๐—ฑ ๐Ÿฎ๐Ÿฌ๐Ÿฎ๐Ÿฌ-๐Ÿฎ๐Ÿฌ๐Ÿฎ๐Ÿญ. These were the ๐’“๐’†๐’„๐’†๐’”๐’”๐’Š๐’๐’ ๐’š๐’†๐’‚๐’“๐’”.

โ€ขEvery time there is a recession, the ten-year T-bond rate decreases. Further, as the real GDP growth decreases, the Fed resorts to ๐’’๐’–๐’‚๐’๐’•๐’Š๐’•๐’‚๐’•๐’Š๐’—๐’† ๐’†๐’‚๐’”๐’Š๐’๐’ˆ to improve liquidity.

โ€ขIn 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.

โ€ขWith access to cheap capital, VC/PE firms leveraged this situation to provide money to startups, ๐™ก๐™š๐™–๐™™๐™ž๐™ฃ๐™œ ๐™ฉ๐™ค ๐™ฉ๐™๐™š ๐™š๐™ข๐™š๐™ง๐™œ๐™š๐™ฃ๐™˜๐™š ๐™ค๐™› ๐™ช๐™ฃ๐™ž๐™˜๐™ค๐™ง๐™ฃ๐™จ.

๐ˆ ๐ฌ๐ฎ๐ฆ๐ฆ๐š๐ซ๐ข๐ณ๐ž ๐ญ๐ก๐ž ๐Ÿ๐จ๐ฅ๐ฅ๐จ๐ฐ๐ข๐ง๐ :
โ€ขThe T-bond rate has to increase momentarily to adjust to rising inflation.

โ€ขThen, for T-Bond rates to go back to 2019, either inflation has to reduce or growth has to dip.

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

โ€ขIf 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.



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