Global real rates and the consumption/wealth ratio - Hard to figure we are headed to higher real rates

Real rates are exceptionally low. We have discussed the trend in real rates in a previous post, "What should be the real rate of interest  - don't expect a positive value in the near-term". The historical view of a 2% real rate should not exist. The low negative real rates will continue not just because of monetary policy also because of secular trends in the consumption/wealth ratio. This secular effect was researched in the BIS paper "Global Real rates: A Secular Approach".

Fluctuations in the consumption/wealth ratio can predict real rates as well as equity risk premia through looking at simple present value calculations on future consumption and wealth. A large fall in the ratio which means a high increase in wealth and will likely indicate a fall in real rates in the future to move the ratio back to the long-term average. The extreme low consumption/wealth ratio cases occurred before the Great Depression and the Great Financial Crisis. Calculating the consumption/wealth ratio is not exactly easy and will be affected by such factors as productivity, demographics, deleveraging, and risk appetite, but even simple measures of consumption to market capitalization suggests that we are at extreme levels.

If you follow the logic, there should be concern about future declines in real rates. Monetary policy today is leading to the conditions that will impact rates and consumption/wealth ratios tomorrow. Conventional wisdom may suggest that real rates are too low when below long-term GDP growth, but there are several factors that suggest that a trend to higher real rates higher in the near-term will be very difficult.

What should be the real rate of interest - don't expect a positive value in the near-term

The long-term history of real interest rates has centered around long-term growth rates and has often been judged to be 2 percent. If we expect a 2 percent real rate, current rates for developed countries are way too low and still suggest very accommodative monetary policy. Clearly at sub-2% US inflation last year, long US real rates were around zero and much higher than for other developed, but the current inflation surge puts US real rates near developed market lows.   

A good analysis of real rates trends can be found in "Global Trends in Interest Rates", a NY Fed research paper from a few years ago. Any updating of their work will only reinforce their thesis on continued low real rate trends. Calculating the real rate and creating a historical real rate series is not easy. Their work shows that the real rate trend has been lower and on a long slide, but real rates are also subject to high variation based on several broad macro factors. These trends are applicable to all developed markets.

Current inflation expectations and actual inflation are pushing real rates to significantly low levels. We are now averaging sub-zero real rates for years. The flight to safety or convenience yield, demographics, slower growth, as well as monetary policy have all pushed long-term real rates lower which suggests that it is hard to handicap nominal rates at much higher than long-term inflation and a term premium. However, even by this measure, yields should move higher, yet continued Fed policy makes any of these forecasts for higher yields suspect. The market distortions will continue as long as QE continues.  

Yield curve term premia for 2021 - From negative to a positive and possibly back again

Term premia have had a wild ride in 2021 as measured by the NY Fed ACM model. The 10-year premium priced in a negative value even for long rates earlier in the year only to see a huge reversal in February and then a decline starting in late May. The premium hit a low surrounding the June FOMC only to bounce back in the last week. The key question is whether the premia should move higher or stay at the current levels. Term premia are not the real yield or expected inflation but the risk of holding a longer-dated bond versus a set of Treasury bill short rates.  

Higher uncertainty about policy, growth, and inflation will all be embedded in the risk premia. Given the changing expectations on the components of yields, it is likely that the premium will increase regardless of real yields and expected inflation.  This should lead to higher yields even if expectations and policy remain stable.

Taylor Rule and rate valuation - Suggesting rates should be higher

Should rates be higher or lower than current levels? Many can provide narratives associated with reasons for rates moving in either direction. The phasing will go something like this, "rates have not priced in all of the inflation we are seeing", or "rates should be pricing in the chance of sooner Fed action, therefore...". To some degree, these are just guesses. If rates are falling, then the weight of market opinion is changing toward lower inflation expectations. If rates are rising, the opposite is occurring. To provide some concrete value decision, we need to have some valuation model that can get into the specific for why rates should be higher or lower.

The Atlanta Fed provides a nice Taylor Rule tool that can be used to estimate what could be the equilibrium rate. They provide more than one specification for the Taylor Rule and the investor can change the weights. There is no "feeling" about rates but some specifics that can be debated based on the model and input assumptions. 

The conclusion from looking at a number of specifications is that rates should be higher based on the modeling provided. Of course, Taylor Rules have been suggesting negative rates during the pandemic and have also pointed to higher rates over the last decade. The Taylor Rule, as a valid tool, can be questioned, but it provides a foundation for discussion. The Fed is not following numbers or past policy. It is targeting inflation at higher level and looking to close all of the output gap from excess unemployment. Under more normal conditions rates should be rising but we are far from normal. 

This discussion at least generates a focus for valuation. we will continue this discussion with a look at r-star and the NY Fed term premium model in another post.