LTPZ: Real Yields May Need To Move Back Below Zero To Prevent A Fiscal Meltdown

The PIMCO 15+ Year U.S. TIPS Index Exchange-Traded Fund (NYSEARCA:NYSEARCA:LTPZ) offers investors exposure to long-term inflation-linked bonds. The fund offers a real yield of 1.7% and significant upside potential if real interest rate expectations return to negative territory. I believe this is highly likely as real GDP growth should average little more than zero over the coming years. This suggests real interest rates will have to be much lower than they currently are to prevent an exponential rise in debt to income ratios across the economy. This is particularly the case for the US government, which faces a potential debt crisis unless real borrowing costs move lower over the coming years.

The LTPZ ETF

LTPZ tracks the performance of the BofA Merrill Lynch 15+ Year US Inflation-Linked Treasury Index. With average maturity of 22 years and a duration of 20 years, the LTPZ is far more volatile than the iShares TIPS Bond (TIP), which has maturity and duration of around 7 years. The fund therefore stands to benefit greatly if we see real borrowing costs move lower, while offering a 1.7% yield in addition to the average rate of CPI growth over time. With an expense fee of 0.2%, the LTPZ's cost is similar to the TIP's 0.19%.

Real GDP Growth To Average Near Zero, Necessitating Lower Real Yields

I have written in several other articles about how US real GDP growth is likely to average around zero over the coming years, and this will force the Fed to drive interest rates down below inflation. To see why, consider that over the past 10 years real GDP growth has averaged 2.2%, which can be broken down into 1.2% growth in employment and 1.0% growth in output per worker. We can further break down employment growth into the growth of the working-age population and the change in the unemployment rate, which both contributed around 0.6% per year to real GDP growth.

Over the next 10 years we should see growth in the working age population continue to slow to perhaps half of that figure, suggesting future real GDP growth will be capped at 1.3% even if productivity growth halts its long-term decline and the unemployment rate remains near record lows. It would therefore take a rise in the employment rate from the current level of 3.6% to just 4.1% by 2033 to result in zero real GDP growth over the next decade.

Fiscal Sustainability At Risk If Real Rates Remain Positive

If real GDP were to average around zero percent as I expect, any positive real interest rate would lead to a rise in debt-to-income ratios across the economy. At 266%, nonfinancial US debt as a share of GDP is the highest it has ever been outside of the height of the Covid crash. The sector most at risk from a rise in real borrowing costs is the government, with its share of total nonfinancial debt reaching its highest level in 60 years at 39%, equivalent to over 100% of GDP and a staggering 5x annual government revenues.

In the absence of any rise in real GDP, real government revenues will stagnate, while real interest costs will continue to rise. Interest expenses on Federal government debt rise to 16% of total government revenues in 2022, which is even higher than in Japan, where the central bank has already been forced to keep bond yields pinned near zero despite rising inflation. There is also precedent for the US Fed keeping bond yields artificially low following the second World War. High levels of government debt forced the Fed to pin the 10-year UST just above 2% even as inflation rose to 20% in 1947.

A Return To Zero Real Yields Would Mean 34% Upside

I firmly believe that the Fed will be forced to drive real bond yields deeply negative over the coming years once again in order to prevent a debt crisis, which would result in extremely positive returns for LTPZ. With a duration of 20 years, a decline in the real yield from 1.7% to zero would result in 34% gains in real terms, while a return to the 2021 yield lows would result in 60% real returns.