In behavioral economics there is a theory called “money illusion,” which is the tendency of people to think of currency in nominal terms, rather than in real, or net of inflation, terms. With nominal interest rates on the rise and at their highest levels in over a decade, it is timely to remind investors of the importance of thinking in real terms, and not just nominal.

1. THE MONEY ILLUSION: LOOK AT WHAT’S “REAL
In behavioral economics there is a theory called “money illusion,” which is the
tendency of people to think of currency in nominal terms, rather than in real, or
net of inflation, terms.With nominal interest rates on the rise and at their
highest levels in over a decade, it is timely to remind investors of the importance
of thinking in real terms, and not just nominal.
Since December 2015, the US Federal Reserve has increased the Federal Funds
rate six times, from an effective 0% yield to today’s 1.75% (as of 5/23/18).The
nominal yield onTreasury bills (those with maturities less than one year) has also
increased, rising from an average of 0.35% in December 2015 to 2.02% today, as
shown in the chart below. After nearly a decade of 0% yields following the
financial crisis of 2007-2008, today’s 2.02% nominal yield on cash-likeTreasury
bills has many investors excited about the prospect of earning a return on their
cash/savings.

2. Source: FactSet, Athena analysis

3. While an increase in yields is a positive data point to support the legitimacy of an
economic recovery, our enthusiasm thus far for the rise in yields is tempered when we
consider the yield net of inflation. Our enthusiasm is further tempered when we
consider the 2.02% yield on a real, post-tax basis.
In the chart below we show the historical real yield and real, post-Federal tax yield of
the six-monthTreasury bill from April 2003 through March 2018.We also show the
nominal yield of the six-monthTreasury bill for context.
Source: FactSet, Athena analysis
Source: FactSet, Athena analysis

4. From the above we see that the current real yield available on six-monthTreasury
bills is positive for the first time since 2008.This is great news for tax-exempt
investors as it meansTreasury bills no longer offer “return free risk.” For taxable
investors, however, there is still 65 basis points to go before the real, post-tax yield is
above 0%.
There are of course a multitude of reasons why an investor may prefer to hold cash,
regardless of the real or real, post-tax yield. However, asTreasury yields rise, we
wanted to remind investors of the money illusion and to think in real terms before
getting too excited about the rise in nominal yields.
Article Resource – https://www.athenacapital.com/blog/the-money-illusion-look-at-
whats-real/