Where next for US real interest rates?

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. 

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.
 

[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).

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