REAL RATES AREN´T YOUR REAL FRIENDS / THE WALL STREET JOURNAL

Real Rates Aren’t Your Real Friends

Inflation-adjusted yields have risen ahead of the Jackson Hole summit. Though this is often linked to a stronger economy, there are less benign explanations.

By Jon Sindreu

Stocks seem to be reacting more negatively to the increase in inflation-adjusted bond yields. PHOTO: Reuters/Brendan McDermid

Markets seem to be waking up to the fact that real interest rates are less helpful than they sometimes sound.

Despite a recovery in the past couple of days, global stocks are having their worst month of 2023. 

As investors await the start of the annual Federal Reserve summit at Jackson Hole, Wyo., Friday, longer-term bonds, gold futures and shares in real-estate investment trusts have all taken downward turns.

The moves have a common driver: So-called real rates—borrowing costs minus expected inflation—keep going up. 

One common gauge of real rates is the yield on inflation-protected government bonds. 

In the U.S., it is now 2.3%, close to a 14-year high. 

The eurozone equivalent is 0.3%, having been deeply negative for most of the period since 2011.

This plainly makes physical assets that are also inflation hedges, such as gold and land, less attractive. 

But the case of stocks is more mixed. 

Many investors argue that higher real yields are a good thing, which is why stocks rallied earlier this year even as rates rose.

Central banks equate real rates with the so-called r-star interest rate required by an economy with stable inflation and low unemployment. 

Higher rates imply higher growth. 

One interpretation of the recent increases is therefore that the post-2008 era of anemic economic growth is finally at an end.

This link between real rates and growth might explain why U.S. stocks have done better than their peers lately. 

Almost the entire increase in Treasury yields since 2021 is explained by the “real” component. 

By contrast, in the weaker eurozone—purchasing managers index data released Wednesday were dismal—bond yields have risen because traders seem to be pricing in permanently higher inflation, with just some additional long-run growth.

Still, valuation multiples suffer when they face more competition from real rates. 

Analysts at Bespoke Investment Group crunched numbers this week showing that stock-market returns since 1997 have been slightly lower after highs in real rates despite faster growth in earnings per share.

Also, there could be technical reasons for the recent increase in real rates that don’t have positive implications for the economy. 

The Bank of Japan recently softened its policy of yield-curve control, and there are fears about the U.S. Treasury’s large coming funding needs. 

Markets could be reassessing the surprisingly small premium they previously demanded to hold longer-term assets, which is why yield curves have steepened.

A deeper issue with assuming higher real rates are always good for stocks concerns their link with monetary policy. 

Economists have traditionally assumed that central bankers mostly just track changes in real rates, which are an independent economic force. 

Were policy to deviate too far, inflation would spiral out of control, and real rates would gravitate back to their “neutral” r-star level, the theory goes. 

However, recent evidence—including this year’s slow fall in inflation—suggests that consumer prices are less sensitive to monetary policy than previously thought, which means central banks have a lot of power to dictate the “real” cost of borrowing when setting interest rates, even over the long term.

This is why many investors are now dreading the possibility of policy makers at Jackson Hole implicitly raising their estimate of r-star. 

Back in June, the Fed’s projections showed that rate setters only expected long-run real interest rates to be 0.5%, which is a quarter of what the bond market is now pricing in. 

If this forecast rises, it is likely that markets would rightly see it as a sign of a more hawkish Fed, not a cheerful consequence of a robust economy.

“If you believe r-star is higher, then the current policy setting by the Fed is easier than we gave it credit for,” said Roger Hallam, global head of rates at Vanguard. 

“If you don’t think r-star is higher, then obviously policy is becoming increasingly restrictive.”

A less growth-focused view of high real rates makes U.S. stock valuations appear more at risk and international equities less unappetizing. 

The real consequences of real interest rates may not have been fully felt yet.