Negative real rates: the foreign situation
Current discussions of raising interest rates by the Federal Reserve include concern that observed inflation rates are higher than the nominal interest rates that are currently being earned in financial markets.
For example, the nominal yield on five-year US Treasuries is currently around 2.30%.
The consumer price index that the Federal Reserve uses as a policy target is around 5.0%.
Thus, the “real” interest rate is about 2.7%.
Another way to look at this is to start with the current nominal yield of 2.30% and subtract the current yield from the Treasury Inflation Protected Securities (TIPs) which are now trading to give a NEGATIVE yield 1.20%.
Here we can calculate the expected inflation rate embedded in the nominal yield of the 5-year Treasury note. In the current situation, the expected inflation rate integrated into the nominal return is 3.50%.
In terms of this type of analysis, for a 5-year risk-free security, investors are faced with the fact that the real rate of return they get in the nominal return market is somewhere between NEGATIVE 1, 2% and NEGATIVE 2.7%. .
Theoretically, these estimates are supposed to be related to the estimate of the expected real growth rate of the economy.
But in the current situation, the real growth rate of the American economy is positive, around 3.0%.
So there seems to be a big divide here between the conceptual and the real.
Foreign flows of funds
I have discussed this many times over the past ten years because it is a very important issue and it tells us a lot about all the conditions of imbalance that exist within the economy, disjointed situations that the Federal Reserve must cope.
What is happening here?
Well, I think the reason rates are showing the relationship they are now is because so many risk-averse foreign funds have been flocking to the US in search of a safe haven.
As the global situation became more confusing, risk-averse investors around the world decided that the best and safest place for them to put their funds was in the United States.
Thus, billions of dollars entered the United States and upset the rate relations that exist in the American markets.
My assumption is that the expected inflation rate that I calculate is always a good estimate of what the investment community believes.
As shown above, the current expectation for the 5-year horizon is 3.50%.
Historically, the expected real economic growth rate for the United States has been around 2.00%, to take the low estimate.
Thus, to obtain the nominal return, we would add to the expected real economic growth rate in the United States, the 2.0%, the expected inflation rate, which we now estimate at 3.5%.
Thus, under “more normal” circumstances, the nominal yield on the 5-year US Treasury should be around 5.50%.
So what’s going on here?
My answer to this question is that large sums of money from risk averse investors have been placed in the United States given the global economic and political situation.
The current period of interest really began in the period called the Great Recession, which ran between December 2007 and June 2009.
Due to the ongoing international turmoil and the way the Federal Reserve was responding to this very severe recession, foreign investors have really started to bring money into the United States.
This graph represents “net” foreign investment, the difference between what American citizens invest “off-shore” and what foreign investors invest in the United States. Since there is more foreign investment in the United States than American investment outside the United States, the number is negative and the more foreign investment in the United States exceeds American investment elsewhere in the world, if larger flows entering the United States than leaving, the number will become more negative.
As can be seen, foreign investment in the United States picked up after the Great Recession and even accelerated as we entered the Covid-19 pandemic and subsequent economic and financial upheaval.
I believe that all this money coming into the United States has distorted the interest rate relationship in the United States.
Most important is the fact that the return on TIPs has turned negative.
Here we see the movement of the yield on the 5-year TIPs. After the end of the Great Recession, when foreign money flowed into the United States, the yield on 5-year TIPs steadily declined and turned negative.
From mid-2013 and into 2014, the flow of foreign capital to the United States slowed and the yield on 5-year TIPs returned to above zero.
But then the spread of the Covid-19 pandemic hit in 2020 and the 5-year TIP yield turned negative again.
And, it remained at a very low level as first the recession, then worries about how major central banks would react to rising inflation, and finally, the Russian invasion of Ukraine darkened the scene. .
This situation is just one more imbalance that the Federal Reserve will have to deal with, sooner or later.
But how will this situation affect the financial markets over the next three months, six months, year or more?
One day, these foreign funds will leave the United States.
The yield of the TIPs will begin to increase.
And the Fed will face a whole new situation in the financial markets with a different interest rate structure.
Given the uncertainty in the world these days, it’s unlikely that these risk-averse funds will start moving offshore in the very near future.
But how will these foreign investors react in the future and what will they do with their money?
It’s a completely different scenario, a real result of radical uncertainty.
The release will happen one day. But what will trigger it? And when?
This paints a different picture for the Fed. Nominal rates are low, not because of too lenient monetary policy. Nominal rates are low due to unusual international fund flows, a condition that has resulted from all the uncertainty that currently exists in the world.
This only adds to the pressure on Mr. Powell and the Federal Reserve to act in a way that maintains the confidence of the global investment community.