Saturday, December 2, 2023

R-star and how to think about interest rates


As we think about interest rates and the continuing great bond debacle, even with the recent decline in rates, we should think about R-star as guide for handicapping the long-term direction of rates.

First, a definition, "The neutral rate of interest (also called the long-run equilibrium interest rate, the natural rate and, to insiders, r-star or r*) is the short-term interest rate that would prevail when the economy is at full employment and stable inflation: the rate at which monetary policy is neither contractionary nor expansionary", from the Brookings institute.

If R-star continues to stay low, the current inflation declines should lead to further decreases in nominal rates. I am not a pure believer in this framework, but it provides context on how the market thinks about rates. For more details on the global r-star, see the bank underground paper from the Bank of England.

The Global r-star value through to 2020 has been close to zero, so the big question is whether the current r-star is moving back to 2%. A move to even 1% since 2020 will make for a very different rate environment for long-term investors. The authors looked at what were the drivers for r-star, and they conclude that it driven by demographics which will not change in the short-run. Nevertheless, even with this headwind, there are other factors which may grow in importance relative to what has been seen in the past. For example, productivity is still a critical driver. 



From a trading perspective, r-star has little value, yet if large investors use r-star as an indicator for their bond allocation, fixed income flows may see significant adjustments. 

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