Falling Real Yields Are Key to Understanding Today's Markets

(Bloomberg View) -- For all the talk about how the Federal Reserve has finally decided to pick up the pace of interest-rate increases, the fact is that real rates -- or those after taking into account inflation -- are not only still negative, but getting even more negative.

Normally, that's not such a bad thing if the goal of a central bank is to spur growth and the price of assets. But the problem now is that negative rates have weighed on the dollar, which is helping to push asset prices to or close to record highs. Although global economic growth is picking up, it's nowhere near levels that would justify such valuations. If history is any lesson, then investors might want to study the 1970s, when the Fed responded to similar conditions by stepping up the pace of rate hikes in an effort to cause real rates to turn positive. The period from mid-1976 through March 1978 wasn't a very good time for stocks and riskier assets in general.

According to Irving Fisher, the early 20th-century economist who is credited with creating the “monetarism” school, when inflation expectations are stable, nominal rates approximate real interest rates. Lately, though, inflation expectations have crept lower, as shown by short-maturity inflation break-even rates falling by 40 basis points after the Fed boosted rates for the second time in three months on March 15.

Japan is an example where inflation expectations became unstable and the Fisher relationship broke down. More recently, Europe and the U.S. have seen volatility in inflation expectations to the extent that Fisher relationships are on the cusp of breaking down for them, too. The consequence is that U.S. and European real interest rates could stay negative, and that may loosen financial conditions even more, cause the dollar to weaken, and spark capital outflows.

Figure 1: The Fisher Relationship

Take the U.K. and the U.S., where in the aftermath of Brexit and Donald Trump's election victory, real interest rates declined and the pound and dollar depreciated, making U.K. and U.S. financial conditions much looser than they normally would have been. The last time that happened was 2007 when the dollar and pound declined, inflation was on the rise, and asset prices rose sharply. What followed was a market correction because real interest rates became too negative. Subsequently, financial conditions tightened and accelerated the sell-off in financial markets in 2008.

Figure 2: Financial Conditions and Real Interest Rates 

Markets are once again facing negative real interest rates and rising asset prices. That can clearly be seen in price-to-earnings multiples for equities which have consistently been on the rise. A measure of inflation expectations volatility is the “Treasury P/E ratio” -- the reciprocal of the five-year real yield from Treasury Inflation-Protected Securities. Looking at history of the 1970s and the 2008 financial crisis, extreme volatility in the Treasury P/E ratio eventually led to a sharp decline in equity P/E multiples.     

 Figure 3: Bond and Stock PE Ratios Compared 

A drop in real interest rates can support riskier assets until they reach extreme valuations. If recent comments from Fed officials are to be believed, a faster normalization of interest rates may be in store for 2017. A material change in the pace of Fed tightening, however, may become a catalyst for negative real rates to reverse. If that were to happen, the change in real interest rates could be the signal of a larger correction coming in global markets.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Ben Emons is chief economist and head of credit portfolio management at Intellectus Partners LLC. The opinions expressed are his own.

To contact the author of this story: Ben Emons at bemons8@bloomberg.net.

To contact the editor responsible for this story: Robert Burgess at bburgess@bloomberg.net.

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