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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