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fedweek.com: inflation and the g fund falling behind Historically, despite having lower returns than equities and most other asset classes, the G Fund has paid higher interest rates than inflation. However, during most of this past decade, and especially at the current time, this is not the case.

Lyn Alden

The G Fund is a unique investment, because it has the risk profile of short-term T-bills (that is, basically no volatility), while offering yields equal to longer-term T-notes and T-bonds.

Specifically, the G Fund pays an interest rate equal to the weighted average yield of all T-notes and T-bonds with four or more years duration. In general, this is very similar in practice to the yield of the popular 10-year T-note, due to the large weighting from the 10-year duration category in this weighting mix.

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Usually, longer-term T-notes and T-bonds pay higher yields than shorter-term T-bills. However, usually late into business cycles, the yield curve “inverts”, meaning that longer-term T-notes and T-bonds pay equal or lower yields than short-term T-bills. We’re in that situation currently; this chart shows the 10-year yield minus the 3-month yield, and it’s currently around zero:

fedweek.com: yield inversion g fund not tracking inflation any more

Chart Source: St Louis Fed

The Federal Reserve controls interest rates on the short end of the curve, while the market usually controls interest rates on the long end of the curve. The market has pushed down the long end of the curve sharply, while the Federal Reserve has also reduced short-term yields by 0.75% over the past year.

Historically, despite having lower returns than equities and most other asset classes, the G Fund has paid higher interest rates than inflation. However, during most of this past decade, and especially at the current time, this is not the case.

This chart shows the yield for the 10-year T-note (blue line), the inflation rate (red line), and the difference between the two (green line).

Chart Source: St. Louis Fed

Chart Source: St. Louis Fed

Currently, the inflation rate is at 2.5%, while the 10-year yield is less than 1.6%. So, in the current rate environment, holders of these treasuries lose approximately 0.9% in purchasing power annually.

Here’s the same chart as above, but zoomed in to the past decade:

fedweek.com: g fund and yield curve inversion - no longer tracking inflation

Chart Source: St Louis Fed

Some areas, like medical care, currently have inflation rates approaching 5%, even as the G Fund compounds at a rate well below 2%.

If we look back a long time in history, we see similar time periods where real yields have been negative before. Here is a chart showing the inflation-adjusted forward annualized returns of 10-year T-notes over the subsequent decade starting from each year (orange bars, 1926-2010), compared to the nominal yield that they offer (blue line, 1926-2020):

There was a large super-cycle of interest rates, with a four-decade increase starting in the 1940’s, peaking in the 1980’s, and has now had four decades of declines.

The period from 1980 to the present has been very good for real bond returns, as interest rates have been firmly above inflation rates for most of the time period. However, the period before that was a multi-decade period of poor real bond returns, where inflation punished bondholders significantly.

So, this chart above presents some of the subtle risks of the G Fund and similar fixed-income investments. The G Fund, and other U.S. government securities, are considered to have zero default risk. They can’t lose money nominally. However, they can certainly lose purchasing power over long stretches of time, which is unfortunate for savers, and is why a diversified portfolio of many different asset classes is generally a good bet.

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