The Rates That Really Matter – Real Rates

Markets have suddenly turned very volatile. One explanation is that everyone seems to have forgotten that it’s not nominal but real rates that matter.

ByDavid Stevenson•08 Aug, 2024•

As I write, markets are in a volatile mood. None of this should come as any great surprise as markets have been in an unbearably bullish mood for far too long, with everyone and their aunt assuming that the U.S. economy might have escaped even a slowdown, let alone a recession. The source of this jittery market sentiment? Friday’s non-farm payrolls figure came in at 114 vs. a 175k expectation with U.S. unemployment rising to 4.3% from 4.1%. Markets reacted very negatively to the miss and while the case for a rate cut builds rapidly, the concerns around a hard landing and deeper recession for the US economy are also escalating. Add in concerns about the geopolitical environment and growing uncertainty about the US election, and you have the makings of a classic sell-off. Oh, and there’s the obvious issue that U.S. tech stocks were over-bought and over-owned.

But I would argue that investors have also indirectly acknowledged the importance of a little discussed term called the real interest rate. The mass media tends to focus on the nominal interest rate, which was reduced last week to 5%. But the real interest rate is far more important. This was first popularised by the economist, Irving Fisher, who argued that we need to consider the importance of inflation in understanding the return on cash rates. He suggested an equation which states that the real interest rate is the nominal interest minus the expected rate of inflation. That last variable, the expected rate of inflation, can be deduced from market measures of the breakeven rate (for anything from 1 to 30 years) for government bonds. That, in turn, can be sourced from the Bank of England’s website, which publishes data on the forward implied inflation rates based on UK bonds. These suggest, currently, that in the UK, the market has pencilled in a 3-year implied inflation rate of 3.84%, a 5-year rate of 3.62% and a 10-year rate of 3.47%. Plug this into the simple equation – let’s go with a blended medium-term rate of 3.7% – and we get a real rate of 1.25% in the UK. By contrast, the U.S. Federal Bank formally publicises its real rate based on forward numbers, with the current 10-year real interest rate running at 2.05%. It also publicises its 10-year breakeven rate, which is, coincidentally, running at 2.04%, with the US nominal interest rate running at 5.33% (which is the Federal Funds Effective rate). The US 1-year (forward) real interest rate is running at 2.5%.

This all sounds terrifically interesting to a dismal economist but the average reader is probably left wondering why it matters. The first point is that long term real interest rates have been heading down steadily for hundreds of years. We tend to think that the last decade of negative real rates (close to zero interest rates and inflation above 1 or 2%) was an unprecedented era, but a paper by Bank of England economists, available freely online, shows clearly and clinically that real rates have been trending to close to zero for decades now, across the world. They call it a supra-secular decline. What’s the driver? Put simply, in our more egalitarian world, its surplus of capital was always going to drive real rates lower. The author concludes, “my new data showed that long-term real rates – be it in the form of private debt, non-marketable loans, or the global sovereign “safe asset” – should always have been expected to hit “zero bounds” around the time of the late 20th and early 21st century, if put into long-term historical context.” As for causes, it’s better to look at the massive accumulation of capital and savings across many developed economies and the declining volatility of both real rates and inflation. The paper also argues that as the capital stock grows relative to labour and other factors of production, the marginal return on capital decreases, leading to lower interest rates. I would also add the idea of secular stagnation as one possible explanation—this once popular idea looks at declining productivity growth rates and lower GDP growth rates and argues that the UK, in particular, but Europe more generally, has struggled to grow at an above-average rate, forcing down real rates. Regardless of the causes, one fact stands out. UK and U.S. real rates are now strikingly positive, even after the recent small cut in the UK. This is fine and dandy for some months and maybe even a year, but eventually, high positive real rates start to have an impact, and I would suggest that the U.S. payroll numbers are the canary in the coal mine – and U.S. equity investors have reacted. They have twigged that there is a possibility that the U.S. Federal Reserve is too hawkish and that their central bankers will now be forced to reconsider and cut rates even quicker than expected. In contrast, in the UK, markets are already betting on more rate cuts in the next six months. Real positive interest rates matter because they throttle investment and act as a disincentive to borrow. That impact isn’t felt immediately, but over a sufficient period – say 1 to 2 years – the pain becomes real, and even governments struggle to find the money to fund their own huge fiscal deficits. Given these widely acknowledged facts, I would argue that a reasonable scenario goes as follows. Both the U.S. and the UK will find themselves in a difficult spot as central banks try and tamp down inflation without completely throttling investment growth. The natural middle ground is that you push the real interest rate closer to +1% in the U.S. – the U.S. economy has probably been overheating in the last year, helped by a massive government deficit, so could probably sustain a positive real rate for a little longer That might suggest a landing place of around 3.5 to 4% for U.S. interest rates by some point in the first half of next year.

Given the UK’s more anaemic growth rate, one might be tempted to bring the real interest rate back to neutral, i.e. close to 0% or possibly as high as +0.5%. Given our longer-term inflation expectations, which are higher than those of the U.S., that might imply interest rates around the 4% level by early 2025.

What does this mean for investment trusts? I would argue strongly that prospects for the myriad of alternative investment trusts, ranging from lending funds to renewable funds, yielding more than 6.5% and some as high as 10%, will now start to look up. Cautiously, I think it reasonable to pencil in some decline in net yields for these funds (especially if they have floating rate debts), but if UK nominal rates stabilise around 4%, then any fund yielding a robust and well-covered yield of above 7% starts to look very compelling. And that list is long and getting longer by the week.