Nominal vs Real Yields: What Smart Money Actually Follows
In the previous chapter, you learned about interest rate differentials. But there's a critical refinement: professional traders don't just compare nominal rates—they compare real yields. This distinction separates retail traders from institutional players.
The Core Concept
Real Yield = Nominal Yield − Expected Inflation
Real yield measures your actual purchasing power gain. A 5% yield with 4% inflation gives you only 1% real return. A 3% yield with 1% inflation gives you 2% real return. The lower nominal rate is actually better.
Why This Matters: A Tale of Two Countries
Imagine two investment scenarios:
Scenario A: High Nominal, Low Real
• 10-year government bond yield: 8%
• Expected inflation: 7%
• Real yield: 1%
Your money grows 8% nominally, but prices rise 7%. Your purchasing power only increases 1%.
Scenario B: Lower Nominal, Higher Real
• 10-year government bond yield: 4.5%
• Expected inflation: 2%
• Real yield: 2.5%
Lower nominal rate, but inflation is contained. Your purchasing power increases 2.5%—more than Scenario A!
Smart money follows real yields, not nominal yields. Institutional investors managing pension funds and sovereign wealth care about maintaining purchasing power over time. They'll choose Scenario B every time.
How to Calculate Real Yields
Two Methods:
1. Using Inflation Expectations (Survey-Based)
Real Yield = Nominal 10Y Yield − Expected Inflation
Use University of Michigan survey or professional forecasts for inflation expectations.
2. Using TIPS (Market-Based, US Only)
Real Yield = TIPS Yield (directly observable)
Treasury Inflation-Protected Securities quote real yields directly. Find them on FRED under "10-Year TIPS".
Trading Real Yield Differentials
Now let's see how real yield analysis works in practice.
Case Study: USD Dominance (2023-2024)
The Setup (Mid-2023):
United States
• 10-year Treasury yield: 4.3%
• Expected inflation: 2.5%
• Real yield: +1.8%
Eurozone
• 10-year Bund yield: 2.5%
• Expected inflation: 2.8%
• Real yield: -0.3%
The Real Yield Differential:
US offered +1.8% real yield while Eurozone offered negative real yields. This 2.1 percentage point real yield advantage for USD created massive incentive for capital to flow from Europe to America.
The Result:
EUR/USD remained under pressure throughout 2023, with periodic rallies quickly fading as investors preferred the superior real returns of US Treasuries. This is fundamental analysis in action—real yield differentials driving sustained currency trends.
Trading Framework:
Always compare real yields across major economies. When one country offers significantly higher real yields, position long that currency against lower-real-yield competitors. This fundamental edge can persist for months or quarters.
When Nominal and Real Diverge
The most interesting trading opportunities appear when nominal rates tell a different story than real rates:
High Nominal + High Inflation = Weak Real
Example: Turkey in 2022 had 14% nominal rates but 80%+ inflation. Real yields were deeply negative (-60%+). Despite "high" rates, TRY collapsed.
Lesson: High nominal rates don't save a currency when inflation is higher.
Low Nominal + Lower Inflation = Strong Real
Example: Switzerland often has low or negative nominal rates, but with near-zero inflation, real yields are close to zero or positive. CHF remains strong because capital preservation is valued.
Lesson: Low rates don't mean weak currency if inflation is even lower.
Pro Tip: Track Real Yield Spreads
Create a simple spreadsheet tracking 10-year real yields for major economies (US, EU, UK, Japan, Australia). When differentials widen significantly (50+ bps change), it often precedes sustained currency moves. FRED has free data for US TIPS (Treasury Inflation-Protected Securities, which directly show real yields). For other countries, use nominal yields minus inflation swaps or survey expectations.