E Entering The Era Of Negative Real Rates Of Interest

In their seminal study, A History of Interest Rates, Sydney Homer and Richard Sylla[1], noted that for much of the post-war era the real rate of interest was a concept only spoken about in academia. This changed with the higher and rising inflation starting in the 1970s, hitting a peak by the end of that decade. No longer were real rates confined to the academic world, rather borrowers and lenders incorporated into their decision-making the role of inflationary expectations. The real rate of interest cannot be directly observed, instead it is has come to be represented by the difference between actual yields and expected inflation in the marketplace. Today, an investor considering the purchase of a 10-yr bond must implicitly have in mind a forecast of the real yield to maturity for the next ten years---- or put differently, the investor must have a view of the expected inflation over the same time period. Holding a bond for that time period traditionally carried considerable risk, hence the need for the investor to have a positive real rate of return. And, certainly, for decades investors demanded real rates of interest that varied around the 2-4 % range, some period even higher. That was then, but now investors do not require any real return and have, in fact, scooped up government and corporate bonds, with negative real rates.

In principle, rising positive real rates of interest are associated with an economic outlook that features expansion. Negative real rates reflect an outlook of economic weakness and possible decline. Starting in the beginning of 2019, real rates, although still positive, began a steady decline and now are hovering around zero or even below.

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Figure 1 US 10yr TIIP rate of interest

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Figure 2 Canada Long Term Real Rate of Return Yield

Regardless of what the equity markets are saying about the near-term outlook, the bond market is giving off an unmistakable signal that growth is going to be so slow, that inflationary expectations have essentially collapsed. Bond investors are satisfied with real rates that are less than zero for the next decade. What should be troubling to most equity investors is that the steady, drum-beat decline in real rates took place all during 2019 when economic growth was above 2% and employment was rising. But bond investors are forced to look beyond the current environment and into a somewhat of a crystal ball as to the prospect’s years out. The fact that crystal ball is telling investors that real rates are likely to be negative is what really matters. Even if one were able to discount accurately the effects of temporary factors, such as the coronavirus, for example, the longer-term picture is hard to ignore.

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Gary Anderson 7 months ago Contributor's comment

Watching growth will be like watching paint dry, prof. Nice charts.