US real interest rates, measured by the 10-year TIPs yield, have climbed nearly back to zero from their low of -1.19% last August (see chart). But for much of the prior economic upswing (pre-Covid) the 10-year TIPs yield ranged in positive territory from 0-1%. So, we should probably expect it to rise further in coming months.
The sell-off in conventional 10-year bonds since early March (about 100 bps) is three-quarters due to the rise in real yields and about one quarter due to a rise in inflation expectations. 10-year TIPs yields are now at -0.12% while the 5-year, 5-year forward inflation expectations rate (derived by comparing 10-year yields with 5-year yields) touched 2.45%, earlier this week, its highest level since 2014. It is now 2.35%. What this means – despite some economists talking about an imminent recession - is that investors have raised their expectations for the strength of the world economy and its resilience to rate hikes.
How high will real rates go?
Real interest rates have trended down since the inception of TIPs (Treasury Inflation-Protected Securities) in 1997 so one view is that they might range even lower in the current upswing than in the last, perhaps staying mildly negative. I find that implausible. The economic upswing in the 2020’s could easily be more robust than in the 2010’s because there are fewer headwinds. Balance sheets are much stronger, with banks, households and most companies in very good shape (excluding a few companies impacted particularly badly by Covid). Asset prices are high with US house prices up 32% over the last 2 years. And fiscal policy is likely to be much less austere in this upswing – remember the fiscal cliff in 2013?
That said, real interest rates are ultimately set by the world savings and investment balance, not just the US economy. Arguments for why real interest rates have been so low in recent decades include the high savings rate in China and low investment in the West due to slowing population growth and the fall in the price of investment goods. Even if these are not going away, it is not immediately apparent that the trend of these factors today points to even lower real rates than in the 2010’s.
There could be temporary factors near-term. For example, current high oil prices provide a windfall to OPEC countries which will show up as higher savings unless or until countries boost spending. Another short-term factor could be the lockdowns in China which might boost domestic savings and cut investment. I suspect both of these factors will recede. Oil prices will probably fall back and/or OPEC will raise spending. And China will get past Covid eventually.
Implications of higher real yields
I expect real rates to move back to positive territory in the next year or two. That means conventional bond yields will rise further as well, if inflation expectations stay where they are (a subject to which we will return). Higher real yields put pressure on stock market valuations, especially growth stocks where much of the return is in the future and must be discounted at the real rate. Stocks can still rise, but their performance depends on rising earnings. Real estate will also face more pressure as funding costs rise and bonds start to offer a better return for those looking for yield.