Real Interest Rates And Fed

Jim Reid, Managing Director and Head of Global Fundamental Credit Strategy at Deutsche Bank, in London, gave us permission to share this marvelous historical chart:

(Click on image to enlarge)

It may give folks pause as they contemplate their forecasts of rapidly changing (rising) inflation rates because the federal deficit is higher than they’re accustomed to. One might actually want to consider how large deficits introduce a deflationary pressure.

Let’s examine Jim’s accompanying narrative, which is excerpted below.

“The big story in financial markets last week was the rise in US real yields (10yrs +20bps) from near 70-year lows. Although we can only calculate using TIPS since 1997, today’s CoTD looks at real yields back to 1800 using the average of the previous 5 years’ inflation against spot 10-year nominal yields.

“In August of last year, real yields went below -1% for the first time since 1952 when we were coming out of a decade of deep financial repression where the Fed controlled interest rates until the 1951 Treasury-Federal Reserve Accord.

“Indeed the only points in history that we’ve seen negative US real yields for any period of time is after big increases in debt. These occurred around the Civil War in the 1860s, WWI, WWII and more recently (but less extreme) after the GFC and now post Covid.

“The difference post GFC to the other negative real yield occurrences is that debt didn’t fall and normality couldn’t return. The other three occurrences all saw much higher inflation and much deeper negative real yields (between minus 5–10% for a few years at least) which helped de-lever debt.

“So with debt so high and likely to go notably higher, it is likely that real yields will have to stay artificially low for a very long period of time. Any return to something close to long-term averages would have grave consequences for debt sustainability.”

Jim ventured this forecast: “The Fed would likely step in well before this point.” He concludes, “There is likely to be a limit to how far real yields can be allowed to rise in the years ahead given where debt levels are.”

We thank Jim Reid for his permission to share his thoughts with our readers. We’re inclined to agree with him.

Low-interest rates are likely to be with us for a while, and very low or negative real rates are here as well. If output gap estimates are close, if alternative employment methods are reasonably close (the unemployment rate is about 11–12%), and, critically important, if COVID-caused deaths and long-term disease estimates are a shock as big as we think they will turn out to be, then the larger deficits and negative real rates are needed for a longer time, to be measured in years, not months.

We believe the Powell Fed understands this. Furthermore, the Fed knows it has to allow the low rates to induce asset inflation for the wealthy. Why? Because that is the way to get employment and labor income rebuilt for the millions of households that are not wealthy.

Our bond strategy continues to include barbells. Our stock market strategy is nearly fully invested. Very low real interest rates are the reason we are maintaining this strategic view.