How Can Interest Rates Go Below Inflation?


Today’s question focuses on interest rates and the fixed income market.

I do not understand how interest rates could be less than inflation. Historically, 90 day tbills track inflation plus a small premium. Now with inflation at let’s say 4% or so, how can everything shorter than 30 years be BELOW the inflation rate…way way below!

First off, we need to make sure we keep in mind that interest rates are determined by markets just like stocks or forex rates or commodity prices. As such they are subject to the same sorts of supply and demand considerations and emotional behavior as any other market.

In the current market environment, safety is a major consideration. People are willing to pay a premium for it, and that means being willing to accept negative real rates of return. This is what is meant by a flight to quality or a flight to safety. I means folks want to put their money somewhere that has virtually no chance of losing them capital.

For those who think of the fixed income market as being the steady, stable one, take a look at this quote board from yesterday’s trading:

Treasury market interest rates on March 24, 2008

I’ve been in this game for a long time and it hasn’t been too many times that I’ve seen movement like that across the board in the Treasury market.


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About the Author
John Forman, author of this blog, has traded for more than 20 years, is a professional market analyst, and authored The Essentials of Trading. He is an active participant in trading forums, consults for trading related businesses, as published literally dozens of trading articles, and has been quoted in a number of books and in the media.
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Read more on Inflation, Interest Rates at Wikinvest

  • http://tradebytrend.blogspot.com Ofir

    Hi,

    If I understand corretly, you claim that people will be willing to get small negative returns on their investment or lose money?