Interest rates may finally become real.
To investors with a sense of history, the near-zero and even negative interest rates of recent years might have seemed unrealistic and, indeed, were unprecedented in the 5,000-year recorded history of such matters. While the recent rise in bond yields has brought rates back within range of their historical norms, they are still below the level of inflation, anticipated or actual, meaning they are negative in real terms.
Last week, the real benchmark 10-year Treasury yield actually touched zero percent, something that hadn’t happened since March 2020. That’s when the Federal Reserve kicked off its hyper-stimulatory monetary policy, cutting short-term rates to almost zero and buying trillions in securities to inject liquidity into the financial system. With the central bank just ending those emergency policies after about two years, the 10-year real rate has finally risen from around minus 1%, where it was in early March.
The concept of real interest rates was developed by the economist Irving Fisher more than a century ago. The nominal rate quoted on an instrument consists of a real rate, plus anticipated inflation over the life of the instrument. Expected inflation is reflected in the “breakeven rate,” calculated by deducting the actual yield on Treasury inflation-protected securities from the yield on the regular Treasury note.
For a time on Tuesday, 10-year TIPS traded at a 0% real yield, while the 10-year Treasury traded at 2.93%, meaning the anticipated breakeven rate of inflation was 2 .93%.
On March 7, the 10-year note returned 1.78%, while the corresponding TIPS changed hands at negative 0.99%, for a breakeven inflation rate of 2.77%. So the recent jump in the Treasury yield was almost all in its real yield.
Positive real interest rates are associated with tighter financial conditions, which is what the Fed is trying to promote to curb inflation. Negative real rates are almost a bribe to borrowers, who can invest cheap money in all sorts of things, wise or not, driving up asset prices. The process works in reverse when real rates rise and turn positive.
Earning bond yields above expected inflation would mark a milestone, perhaps one signaling a shift to tight monetary policy, says Ed Hyman, the ever-highest-rated economist who heads Evercore ISI. But it is more complicated, he explains in a telephone interview.
Seen the other way around, the fed funds rate is even further behind the Treasury bond yield, which makes the policy highly stimulative. “You have to get bond yields and federal funds in the same neighborhood,” he says. Right now they’re not even in the same zip code, with fed funds, the central bank’s key rate, just a quarter of a percentage point above its pandemic policy floor, at 0.25%-0.50%, well below the Thursday night’s 10 year performance. of 2.91%.
The real rate (negative 0.13% on Thursday, down from 0% earlier in the week), while up almost a full percentage point in about six weeks, is still well below the most recent reading for the US price index. consumer, which soared 8.5%. in the 12 months ending in March. Based on the current “spot” inflation rate, rather than the TIPS break-even point, the 10-year real yield is still in negative territory, at about minus 5.6%, according to Jim Reid, head of thematic research. of Deutsche Bank.
Given that big gap, he’s skeptical of the bond market’s prediction of future inflation of around 3%. “I am still not convinced that inflation will fall close enough in the next two years for real yields to approach anything positive,” he writes in a research note. They will most likely remain negative, due to “financial repression” by central banks. If real yields rise (more likely due to higher nominal yields than a faster reduction in inflation), he warns, “go for the hills, given the global debt buildup,” with a potential explosion in servicing costs. Of the debt.
Most people aren’t rational enough to analyze all that, argues Jim Paulsen, chief investment strategist at Leuthold Group, so he doesn’t think actual returns matter that much. And, he adds in a phone interview, low or negative real yields are generally associated with weak growth and low confidence, so they may not stimulate the economy. In fact, if people see yields going up again, it can restore a sense of normalcy and boost confidence.
For the stock market, he finds that nominal rates mean more than real returns. And the key turning point is when the benchmark 10-year Treasury yield crosses 3%, as it appears poised to do.
Since 1950, when this yield has been below 3%, stocks have done well. But they have done worse when it was higher (and even worse when it exceeded 4%). When the return was below 3%, annualized monthly returns on stocks averaged 21.9%, versus 10.0% when returns were higher, according to Paulsen’s research. Also, volatility was lower (13.5% versus 14.6%), while monthly losses were less frequent (occurring 27.6% of the time, versus 38.2%). More specifically, there was only one bear market when the yield was below 3% during the period studied, but 10 when it was above that level.
Hyman worries that when the fed funds rate and bond yields get close, there could be a financial crisis. How bad is a crisis? He points out that, in 2018, when the Fed was raising the funds rate while shrinking its balance sheet, the
S&P 500
fell 20% at the end of the year. Then Fed chief Jerome Powell took a turn and declared that he would be “patient” regarding further rate hikes; he ended up cutting rates in 2019.
Read more up and down Wall Street: Here come the interest rate hikes. They could be even worse than you expected.
Not all financial crises lead to economic recessions. In a client note, Hyman lists episodes of Fed tightening that precipitated what he calls crises without causing a recession. Among them, 1994 stands out, when the central bank doubled the funds rate, from 3% to 6%, in a short time. What followed was a rout in the mortgage-backed securities market; the bankruptcy of Orange County, California, whose treasurer had speculated in financial derivatives; and the Mexican peso crisis that resulted in a $50 billion US bailout. However, there would be no recession for the rest of the century.
So how serious is the threat of a real bond yield that is no longer negative? Start to worry when the Fed raises its fed funds target near bond yields. But, as Hyman observes, Powell & Co. “have a lot of wood to cut” before that happens.
write to Randall W. Forsyth at randall.forsyth@barrons.com
