Multi-asset

Where next for US real interest rates?

Where next for US real interest rates?
Florian Ielpo, PhD - Head of Macro, Multi Asset

Florian Ielpo, PhD

Head of Macro, Multi Asset

To celebrate the three-year anniversary of our weekly Simply put commentary, we return to a favourite topic: the level of real interest rates. We explore where US rates might head next, depending on the economic context, and why this changes the picture for fixed-income exposures in multi-asset portfolios. 

 

Need to know:

  • Three years ago, our inaugural edition of Simply put delved into the topic of real interest rates. We revisit the topic and examine the outlook
  • The trajectory of real rates from here will heavily depend on the prevailing economic scenario. A slowdown could see real rates decline, while further expansion would underpin stabilisation
  • After assessing the potential paths forward for rates, we ask: should multi-asset investors rethink their bond exposures?

 

“The real voyage of discovery consists not in seeking new landscapes,
but in having new eyes”
– Marcel Proust, La Prisonnière (1923)

A 3-year journey of macro analysis without fuss

Three years ago, we embarked on an intellectual journey when we launched our first issue of Simply put. Recognising that the macro landscape is complex and ever-changing, we felt a new take was needed: deep analysis presented in straightforward terms. Thus, Simply put was created as a weekly commentary making macro calls in uncomplicated terms from a multi-asset perspective.

Since then, no economic indicator, school of thought, market move or central bank policy has been outside our scope as we seek to provide a fresh perspective on a world in flux. In time, we integrated into the commentary our nowcaster indicators, which were produced as part of a macro risk premia overlay to help adapt our All Roads multi-asset strategy to economic developments. As we covered the distance over the years, the nowcasters have provided useful signposts to inform our views.

 

Reflecting on real rates

Today, to reflect on our journey, we return to a favourite topic: real interest rates. At the time of our inaugural edition in September 2021, real interest rates were negative on both sides of the Atlantic. We discussed their potential normalisation and predicted that they would rise by 50 basis points by the end of 2021, pushing US 10-year Treasury yields to 1.8%. Our forecast proved quite accurate for 2021, but real rates accelerated dramatically in 2022, surging by 250 bps as inflation proved itself persistent in a seismic shift of the investment landscape.

Some three years later, this week’s Simply put reassesses the status of real interest rates. Have they indeed normalised? What factors could galvanise a sustained return to ‘normal’ levels? And should multi-asset investors rethink their bond tilts?

 

How central banks and savers drive rates

There are two macroeconomic drivers of real interest rates: the amount of savings available in a given currency and the monetisation of debt by central banks.

  • Real rates as the 'price' of capital. Real interest rates essentially represent the cost of capital in real terms. When savings are abundant, as they were following extensive stimulus programs after the Covid-19 pandemic, the excess supply drives down their price, leading to lower real rates. For instance, US public aid – such as federal stimulus cheques – caused total savings to spike from 45% to 58% of GDP1, softening real rates from 1% to -1%. The subsequent contraction of these savings has been a key factor in the normalisation of real rates
  • Central-bank activities. Quantitative easing, or bond-repurchase programmes, monetise part of government debt by converting it into cash, and have historically depressed the value of cash. The normalisation of the Federal Reserve's (Fed’s) monetary policy through quantitative tightening has recently reversed some of these effects

While it was relatively straightforward to anticipate the dynamics of savings and central bank policies in September 2021, the path forward now appears more complex. With an economic slowdown looming, the Fed may slow the pace of its balance-sheet normalisation. Additionally, a cooling of the economy might prompt US households to save more. These dynamics could potentially cause real long-term rates to continue their descent, though the magnitude of this movement remains uncertain.
 

FIG 1. Real rates and savings (left) and the Fed’s balance sheet (right)

Source: Bloomberg, LOIM. As at 04/09/2024. For illustrative purposes only.
 

A tale of two growth scenarios

Divergent scenarios for growth have been a prominent theme in market analyses lately, though opinions vary widely. The future trajectory of real interest rates hinges critically on whether the economy slows or maintains steady growth. To illustrate these divergent paths, figure 2 provides a quantitative analysis of how two economic scenarios could impact the evolution of US real rates over the next decade.

  • Economic slowdown. According to our nowcasting indicators, the likelihood has increased of the US economy cooling off. Historically, such economic conditions have led to increased savings among US households: this is similar to 2008, when savings as a percentage of income rose by 2% to 4.5%, even as GDP growth decelerated. This behavioural shift towards higher savings could, once again, push the savings ratio higher relative to GDP. Under these circumstances, it might become challenging for the Fed to continue reducing its balance sheet. A potential resumption of buyback programmes could then be on the cards. Together, these factors are likely to keep real rates around 1.49%
  • Continued economic expansion. If growth remains robust, we could expect a normalisation of savings and a stabilisation of the central bank’s balance sheet. In such a scenario, real rates might stabilise at around 2%, representing a so-called ‘new normal’

These two potential outcomes are highlighted in figure 2. It's crucial to understand that the 1.75% level should not be viewed as a fixed anchor for sustainable real rates. Depending on the economic context, deviations of about 25 bps, either upward or downward, are entirely plausible.


FIG. 2. Real 10-year rate heatmap relative to savings and the Fed's balance sheet

Source: Bloomberg, LOIM. As at 04/09/2024. For illustrative purposes only.


What this means for All Roads

Several weeks ago, we discussed our renewed interest in duration risk that was spurred by a rethink of our fixed-income exposure. This adjustment marks a significant change from the past three years, during which our underweight stance in bonds was quite an anomaly compared to the decade before2.

Our decision to pivot back towards bonds was influenced by a few key factors. Our growth indicators have been signalling a slowdown, suggesting a potentially less robust economic environment ahead. Additionally, there has been a noticeable improvement in bond trends, coupled with a decline in volatility within this asset class. These developments make bonds a more attractive investment.

Our management indicator cockpit aligns with the first economic slowdown scenario that we previously outlined – this suggests a retreat in real rates to lower levels. Such an environment could prove beneficial for diversified investors like us, providing a performance boost as lower real rates typically enhance the attractiveness of bonds.
 

Simply put, real rates could continue to fall if the US economy slows. In this environment, we believe multi-asset investors could find value in greater exposure to fixed income.

To learn more about our risk-based approach to multi-asset investing, click here.

[1] Source: Federal Deposit Insurance Corporation (FDIC)
[2] Holdings and/or allocations are subject to change.

 


Macro/nowcasting corner

The most recent evolution of our proprietary nowcasting indicators for global growth, inflation surprises and monetary-policy surprises is designed to track the recent progression of macroeconomic factors driving the markets.
Our nowcasting indicators currently show:

  • Growth continues to slow down, and this week's economic data further supports this trend, notably in the US
  • Slowly but surely, inflationary pressures are rebuilding, as wage growth remains elevated and service-sector inflation proves stickier than expected
  • Regarding monetary policy, the global pivot of G10 central banks, excluding Japan, is about to unfold, and markets are counting on easing to offset the negative impact of a slowing global economy


World growth nowcaster: long-term (left) and recent evolution (right)


World inflation nowcaster: long-term (left) and recent evolution (right)


World monetary policy nowcaster: long-term (left) and recent evolution (right)

Reading note: LOIM’s nowcasting indicator gather economic indicators in a point-in-time manner in order to measure the likelihood of a given macro risk – growth, inflation surprises and monetary policy surprises. The nowcaster varies between 0% (low growth, low inflation surprises and dovish monetary policy) and 100% (the high growth, high inflation surprises and hawkish monetary policy).

important information.

For professional investors use only

This document is a Corporate Communication and is intended for Professional Investors only. 

This document is a Corporate Communication for Professional Investors only and is not a marketing communication related to a fund, an investment product or investment services in your country. This document is not intended to provide investment, tax, accounting, professional or legal advice.

This document is issued by : 

Lombard Odier Asset Management (Europe) Limited (hereinafter the “Company”). The Company is authorised and regulated by the Financial Conduct Authority (the “FCA”), entered on the FCA register with registration number 515393. 

This document is approved at the date of the publishing. The Company is clustered within the Lombard Odier Investment Management Division (“LOIM”) of Lombard Odier Group which support in the preparation of this document and LOIM is a trade name.

Any opinions or forecasts provided are as of the date specified, may change without notice, do not predict future results and do not constitute a recommendation or offer of any investment product or investment services.

This document is the property of LOIM, is provided for information purposes only and is addressed for the recipient exclusively for its personal use. It may not be reproduced (in whole or in part), transmitted, modified, or used for any other purpose without the prior written permission of LOIM. It is not intended for distribution, publication, or used for any other purpose without the prior written permission of LOIM. 

The contents of this document are intended for persons who are professionals and who have been vetted by LOIM and assessed as suitable to the investment matters set out in this document and in respect of whom LOIM has received an assurance that they are capable of making their own investment decisions and understanding the risks involved in making investments of the type included in this document or other persons that LOIM has expressly confirmed as being appropriate recipients of this document. If you are not a person falling within the above categories, you are kindly asked to either return this document to LOIM or to destroy it and are expressly warned that you must not rely upon its contents or have regard to any of the matters set out in this document in relation to investment matters and must not transmit this document to any other person. This document contains the opinions of LOIM, as at the date of issue or completeness of the information contained in this document, nor does it accept any liability for any loss or damage resulting from its use. All information and opinions as well as the prices indicated may change without notice.

The contents of this document has not been reviewed by any regulatory authority in any jurisdictions and does not constitute an offer or a recommendation to subscribe for any securities or other financial instruments or products.   

It contains opinions of LOIM, as at the date of issue. These opinions and information contained herein in this document does not take into account all the specific circumstances of the addressee. Therefore, no representation is made that the information presented in this document are suitable or appropriate to the individual circumstances of any investors. Tax treatment depends on the individual circumstance of the investor and may be subject to change in the future. LOIM does not provide tax advice. 

The information and analysis contained herein are based on sources believed to be reliable. While LOIM uses its best efforts to ensure that the content is created in good faith and with greatest care, it  does not guarantee the timeliness, accuracy, validity, reliability or completeness of the information contained in this document, neither does it warrant that the information is free from errors and omission not does it accept any liability for any loss or damage resulting from its use. All information and opinions as well as the prices indicated may change without notice. Particular contents of third parties are marked as such. LOIM assumes no liability for any indirect, incidental or consequential damages that are caused by or in connection with the use of such content. 

The Source of the data has been mentioned wherever it was available. Unless otherwise stated, the data is prepared by LOIM. 

Not for US Person: This corporate communication is not intended for any "U.S. Person" as defined in Regulation S of the Act, as amended or pursuant to the 1940 United States Investment Company Act as amended and will not be registered pursuant to the 1940 United States Investment Company Act as amended, or pursuant to other US federal laws. Neither this document nor any copy thereof may be sent, taken into, or distributed in the United States of America, any of its territories or possessions or areas subject to its jurisdiction, or to or for the benefit of a United States Person. For this purpose, the term "United States Person" shall mean any citizen, national or resident of the United States of America, partnership organized or existing in any state, territory or possession of the United States of America, a corporation organized under the laws of the United States or of any state, territory or possession thereof, or any estate or trust that is subject to United States Federal income tax regardless of the source of its income.
 
Data Protection: You may be receiving this Communication because you have provided us your contact details. If this is the case, note that we may process your personal data for direct marketing purposes. For more information on Lombard Odier’s data protection policy, please refer to www.lombardodier.com/privacy-policy 
 
©2024 Lombard Odier IM. All rights reserved.