Low real interest rates support asset prices, but rising risks
Supply disruptions coupled with strong demand for goods, rising wages and rising commodity prices continue to challenge economies around the world, pushing inflation above central bank targets .
To contain price pressures, many economies began to tighten monetary policy, causing nominal interest rates to rise sharply, with long-term bond yields, often an indicator of investor sentiment, returning to pre- pandemic in certain regions such as United States.
Investors often look beyond nominal tariffs and base their decisions on real rates, i.e. inflation-adjusted rates, which help them determine the return on assets. Low real interest rates encourage investors to take more risk.
Despite somewhat tighter monetary conditions and the recent uptrend, longer-term real rates remain deeply negative in many regions, supporting higher prices for riskier assets. Further tightening may still be needed to bring inflation under control, but this puts asset prices at risk. More and more investors could decide to sell risky assets because these would become less attractive.
Although short-term market rates have risen since central banks’ hawkish turn in advanced economies and some emerging markets, there is still a clear difference between policy makers’ expectations about when their benchmark rates will rise and where investors expect the crunch to end.
This is particularly evident in the United States, where Federal Reserve officials expect their main interest rate to hit 2.5%. That’s more than half a point higher than 10-year Treasury yields indicate.
This divergence between the views of markets and policymakers on the most likely path for borrowing costs is important because it means that investors can adjust their expectations of upward Fed tightening at a time more far and faster.
In addition, central banks could tighten more than they currently expect due to the persistence of inflation. For the Fed, this means that the main interest rate at the end of the tightening cycle could exceed 2.5%.
Implications of Debit Path Splitting
The path of policy rates has important implications for financial markets and the economy. Due to high inflation, real rates are historically low, despite the recent rebound in nominal interest rates, and are expected to remain so. In the United States, long-term rates are hovering around zero while short-term yields are deeply negative. In Germany and the United Kingdom, real rates remain extremely negative on all maturities.
These very low real interest rates reflect pessimism about economic growth in the years to come, the global glut of savings due to aging societies and the demand for safe assets in a context of heightened uncertainty exacerbated by the pandemic and recent geopolitical concerns.
Unprecedented low real interest rates continue to boost riskier assets, despite the recent uptrend. Low real long-term rates are associated with historically high price-to-earnings ratios in equity markets, as they are used to discount expected future growth in earnings and cash flow. All other things being equal, the tightening of monetary policy should trigger an adjustment in real interest rates and lead to a rise in the discount rate, leading to a decline in stock prices.
Despite the recent tightening of financial conditions and worries about the virus and inflation, global asset valuations remain stretched. In credit markets, spreads are also still below pre-pandemic levels despite a slight recent widening.
After a banner year supported by strong earnings, the US stock market entered 2022 with a steep decline amid high inflation, growth uncertainty and a weaker earnings outlook. Therefore, we anticipate that a sudden and substantial rise in real rates could lead to a significant decline in US equities, especially in highly valued sectors like technology.
Already this year, the real 10-year yield has risen by almost half a percentage point. Stock volatility soared on heightened investor jitters, with the S&P 500 falling more than 9% for the year and the Nasdaq Composite measure dropping 14%.
Impact on economic growth
Our Growth at Risk estimates, which link downside risks to future economic growth to macro-financial conditions, could rise significantly if real rates suddenly rise and financial conditions tighten. Easy conditions have helped governments, consumers and businesses around the world weather the pandemic, but that could reverse as monetary policy tightens to curb inflation, moderating economic expansions.
In addition, capital flows to emerging markets could be threatened. Equity and bond investments in these economies are generally considered less safe, and tighter global financial conditions may lead to capital outflows, particularly for countries with weaker fundamentals.
Going forward, with persistent inflation, central banks are faced with a balancing act. Meanwhile, real interest rates remain very low in many countries. The tightening of monetary policy must be accompanied by some tightening of financial conditions. But there could be unintended consequences if global financial conditions tighten significantly.
A larger and sudden increase in real interest rates could lead to a disruptive revaluation of prices and an even larger sell-off in equities. Given that financial vulnerabilities remain elevated in several sectors, monetary authorities should provide clear guidance on the future direction of policy to avoid unnecessary volatility and safeguard financial stability.