The real story of negative real rates

A fairy tale in the markets

Recent inflation has been exceptionally high and few of us lived through such a situation. As usual, the FinTwit crowd became real rates experts. My curiosity drove me to do some research and share it with you.

Let’s start with the basics. What are real rates?

To understand real rates, you need to understand inflation first. “Inflation is a general, sustained upward movement in the prices of goods and services in an economy.”

The Fed has the following definition for real rates:

A “real interest rate” is an interest rate that has been adjusted for inflation. To calculate a real interest rate, you subtract the inflation rate (& inflation risk premium) from the nominal interest rate. In mathematical terms we would phrase it this way: The real interest rate equals the nominal interest rate minus the inflation rate and a premium for the risk of inflation rate (aka not knowing exactly what it will be).

We now have a basic idea of how the Fed derives real yields.

Now that we know that, can you deduct the current inflation rate from the 10-year coupon’s yield of a 10 years note? Not really, because during these 10 years, the inflation rate won’t stay constant. So this is why the Fed is using investors expectations for inflation to assess the 10 year real rate.

What about all these tweets saying real yields are -5%?

You probably saw many tweets like these in the past weeks.

I understand the feeling and the concept that you would lose more or less 5% this year due to the high level of inflation. But whatever you call that, these are not real yields…. Unless you look at T-bills.

Real yields have been falling, should I be worried? (Inspired by P. Schmelzing)

Falling real yields is not a new phenomenon. Although the discussion is often confined to the second half of the 20th century (70s inflation then the subsequent multi decades fall in rates), this is a trend that dates back from the 14th century.

Here is a regression of the GDP-weighted decline in real rates.

We can observe a decline from -1.59 bps (basis point) per annum for the entire sample to -2.29 bps per annum for the post-Napoleonic period. “The average real rate since 1311 stands at 4.64% for the safe asset provider; the average real rate over the last 200 years stands at 2.30%. On both measures, therefore, current real rates (at 0.30% as of end-July 2019) are historically severely depressed, but in fact “in line” with historical trends (the mean historical 0.55%). The year-end 2017 real rate (0.81% moving average) fell just shy of the 90th-percentile threshold for the lowest real rates across the dataset.”

We can also notice that the frequency of negative real rate episodes has been increasing over time. 63% of all negative real rate observations have occurred in the 20th century.

For the curious, here are the details of the data points for the different periods.

“The “historically implied” safe asset provider long-term real rate stands at 1.56% for the year 2018, which would imply that against the backdrop of inflation targets at 2%, nominal advanced economy rates may no longer rise sustainably above 3.5%.”

We can also note that the negative real rates trend appears to be independent of the establishment of central banks and “active monetary policy”; “it is independent of the dominant currency form (gold, silver, mixed gold-silver, or fiat)”.

Extrapolating real rates, using the most conservative approach, we find that by 2027 real rates will permanently turn negative.

These negative real rates will soon constitute a “new normal” and they will continue to fall constantly. In addition, current levels of real rates (to the exception of 2021-2022) are “depressed” but fully “at historical trend”.

How is the market reacting to real yields?

Recent history shows us that the market is highly correlated with real yields (inverse correlation). Here is the S&P500 and the 5-years real rates (inverted) since 2020.

I found that the 5 years-yield was the best proxy. This trend is also visible on a longer period and with the broader market (Wilshire 5000 total market cap).

I compared the 1-year return of each month since 2004 with the one year change in the 5-year real rate and found a statistical correlation (p-value 0,014613). We can see that a positive change in the 5-year real rate (a proxy for adverse financial conditions?) implies lower returns and that the opposite holds true. Although the returns in 2021 have been exceptional, they corroborate our story.

Returns for January 2022 are totally in line with what we could expect from the historical average and the correlation with the real rates.

What is my alpha in this?

I then analysed the short term trend of the 5 year real rates. Using a simple regression, I extrapolated this trend line since the 80’s. This corresponds also to P. Schmelzing timelines on negative real rates.

I repeated the process with a logistic regression and this gave me better statistical results.

It is clear that the real rates are fluctuating around the trend lines but tend to “return to the mean”. 2021 was an outlier year and real rates will likely go back to the trend in the coming months or years either by an increase in nominal rates or a decrease in inflation expectations. As real rates increase back to or above the trend, opportunities in the markets will emerge.

This valuable information provides investors with a roadmap on how and when to rebalance their portfolios.

What is the end game?

For a long time, I wondered what was the end game, as we were reaching the time when real rates would go negative. That was unavoidable. There were 3 paths:

• Move from the debt economy model to a new model

• Have negative nominal rates

• Have a new -higher- inflation regime

It seems that by design or fortuity the later happened - at least for now-. Does that change anything for investors? Not really, the model still favours the borrowers and annuitants to the workers. The trend is the same and negative or not the decay is what matters. Deviations from the trend will appear again and provide investors with buying and selling opportunities.

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Sources:

https://www.federalreserve.gov/econres/notes/feds-notes/tips-from-tips-update-and-discussions-20190521.htm

https://www.stlouisfed.org/education/economic-lowdown-podcast-series/episode-14-getting-real-about-interest-rates

https://www.investopedia.com/terms/t/tips.asp

https://fred.stlouisfed.org

BOE, Staff Working Paper No. 845, Eight centuries of global real interest rates, R-G, and the ‘suprasecular’ decline, 1311–2018, Paul Schmelzing