In early 2020, global nominal interest rates converged around zero, with the US (at the 10-year maturity point) under 1% and the EU slightly negative. The monetary spigots were on, and central banks coordinated to squirt liquidity everywhere they could. Since that time, as monetary policy has diverged somewhat, nominal interest rates have diverged. Notably, Japanese rates remained lower than other developed country rates, but in general the picture spread out a bit.

What is interesting, though, is that this behavior of nominal rates obscures what is really happening ‘under the hood’ so to speak. Recall that nominal rates are (approximately) the sum of real rates – the cost of money – and compensation for expected inflation. Thanks to the CPI swaps market and/or the inflation-indexed bond market, we can break nominal rates into these two components. The evolution of those two components tells very different stories depending on the country or region. For the purposes of this article, I’m considering the US, EU, Japan, and the UK. Obviously the UK is the smallest economic unit there but they have the oldest inflation-linked bond market so they’re a crowd favorite.

In 2020, the UK had the highest implied inflation of this set, and the lowest real rates. In the UK, long-term real rates have been persistently very much lower than in the rest of the developed world, mainly because pension fund demand caused long-term linkers to be outrageously expensive.[1] On the other end of the curve, investors in Japanese inflation have persistently priced near-deflation so that in 2020 Japan had the lowest implied inflation and the highest real rates. So, even though Japan and the UK had very similar 10-year nominal rates, the composition of those real rates was wildly different. Note that in the second chart below, I am representing real rates as the spread between LIBOR/SOFR rates and the CPI swap rates, rather than looking at the inflation bond yields.[2]

Collectively, what these charts say is that inflation expectations across many disparate economies are converging, and right now that convergence looks like it’s headed to roughly where the US is at 2.5% (adjusting for differences in index composition). On the other hand, the cost of money is not noticeably converging, although real rates are gradually rising across many economies. Real interest rates are supposed to roughly reflect equilibrium economic growth, so the picture seems to be of gradually strengthening long-term equilibrium growth expectations across the US, EU, Japan, and UK, with the US having the strongest expected growth and Japan the weakest. Notably, the UK real rate has moved above the EU’s rate, which seems to make sense to me given the hot mess Europe is right now.

I don’t think this has any hot money trading implications. But I do think it’s useful to understand that while nominal rates remain different across economies, that’s becoming more and more due to differences in real rates and less and less due to differences in expected inflation rates. Of course, you can also see that the average cost of money globally is rising. Eventually, that could cause issues for other asset classes.

[1] Naturally, there are also some differences in the inflation definitions from one country to the next, and differences in what index is used for inflation swaps, which can account for some of these differences and explain why they never will, nor should, fully converge. I am abstracting from these differences; just look at the overall trend rather than try to read too much into the absolute differences, which may have good economic reasons.

[2] One reason I am doing so is that the JGBi bonds, unlike the inflation bonds in the US, UK, and Europe, do not have a deflation floor so that when inflation is very low, the real yields on those bonds naturally diverge because of the value of the embedded deflation floor. Which isn’t what we’re trying to look at.

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