Wednesday, August 21, 2024

So what is the right bond interest rate level? it may not be much lower



What is the right level of interest rates? if you ask investors what rates will be in the next year, the answer is lower, a lot lower. However, it may be worth stopping for a second and think about the history of interest rates. 

There usually is a term premium in the yield curve. Long rates are riskier than short rates. There is duration risk and there is more systematic risk when the correlation between stocks and bonds is positive. If the front-end of the curve declines, there is no guarantee that long rates will also fall in lockstep. The curve is likely to get steeper. Without QE and with large budget deficits, there also is upward pressure on longer-term rates. 

Real rates are usually positive and near the long-term growth rate of the real economy. A zero real rate environment is not usual, so just because inflation has fallen does not mean that real rates will again fall to zero or lower. 

The economy may be slowing, but that is not the same thing as an economy going into a recession. Without a recession, it may be hard to argue that long rates will see a significant fall.

As usual, market sentiment will often get overly pessimistic or optimistic and a more tempered view may be appropriate.

 

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