Low real interest rates support asset prices but increase risks
Tobias Adrian et Nassira Abbas
January 27, 2022
A sharp and sharp rise in real interest rates could eventually trigger a decline in equities.
Supply disruptions, combined with strong demand for goods, rising wages and rising commodity prices, remain a challenge for countries around the world, with inflation exceeding the bank’s targets central.
To contain price pressures, many countries have begun to tighten their monetary policy, resulting in a significant increase in nominal interest rates. Additionally, long-term bond yields, which often serve as an indicator of investor sentiment, are returning to pre-pandemic levels in some regions such as the United States.
Investors often don’t just look at rates nominal : base their decisions on tariffs real, that is, inflation-adjusted rates, which help them determine asset returns. Low real interest rates encourage investors to take more risks.
Despite a slight tightening in monetary conditions and the recent upward trend, longer-term real rates remain strongly negative in many regions, supporting the high prices of riskier assets. Further tightening may still be needed to keep inflation in check, although this poses a threat to asset prices. More and more investors may decide to sell risky assets as they become less attractive.
Different points of view
Although short-term market rates have risen since central banks have adopted an offensive tone in advanced and some emerging economies, there remains a notable difference between the expectations of authority as to the level that their key rates and those of the investors on the final extent of the tightening.
This is especially noticeable in the United States, where Federal Reserve officials expect their prime interest rate to hit 2.5%. This is more than half a point higher than 10-year Treasury bond yields suggest.
These divergent views among markets and authorities about where borrowing costs are most likely to go are important because they mean that investors could correct their expectations of the Fed’s tightening upward policy in both a more pronounced and faster way.
Furthermore, central banks could tighten policy more than they currently expect due to persistent inflation. For the Fed, this means that the prime interest rate at the end of the tightening cycle could exceed 2.5%.
Consequences of diverging views on the trajectory of interest rates
The trajectory of official rates has important consequences for the financial markets and the economy. Due to high inflation, real rates are historically low, despite the recent rebound in nominal interest rates, and should remain so. In the United States, long-term rates hover around zero, while short-term yields are strongly negative. In Germany and the UK, real rates remain extremely negative across all maturities.
These very low real interest rates are explained by the pessimism about economic growth in the coming years, the excess saving on a global scale due to an aging population and the demand for risk-free assets amid the growing uncertainty amplified by the pandemic and recent geopolitical issues.
Historically low real interest rates continue to strengthen riskier assets, despite the recent hike. Low long-term real rates go hand in hand with historically high earnings capitalization ratios in equity markets, as they are used to predict earnings growth and expected cash flows in the future. All other things being equal, the tightening of monetary policy should lead to an adjustment of real interest rates and an increase in the discount rate, which would result in a reduction in share prices.
Despite the recent tightening of financial conditions and fears over the virus and inflation, asset valuations remain strained globally. In credit markets too, credit spreads remain below pre-pandemic levels, despite a moderate widening in recent times.
After a bumper year of solid earnings, the US equity market started 2022 with a steep decline amid high inflation, growth uncertainty and worsening earnings outlook. As a result, we believe that a sudden and significant rise in real rates could cause US equities to fall sharply, particularly in highly valued sectors such as technology.
The 10-year real yield has already risen by almost half a percentage point this year. Equity volatility soared on renewed investor concern, with the S&P 500 down more than 9% for the year and the Nasdaq Composite down 14%.
Impact on economic growth
Our risky growth estimates, which link the risks of slower economic growth in the future to macro-financial conditions, could rise significantly in the event of a sharp rise in real rates and a tightening of global financial conditions. The accommodative conditions have enabled administrations, households and businesses around the world to cope with the pandemic. However, the situation could change given the tightening of monetary policy to contain inflation, which would moderate economic expansion.
In addition, capital flows to emerging countries could be threatened. Equity and bond investments in these countries are generally viewed as less secure and tighter global financial conditions could trigger capital outflows, especially for countries with weaker economic fundamentals.
In the face of persistent inflation, central banks will have to engage in a balancing exercise. Meanwhile, real interest rates remain very low in many countries. The tightening of monetary policy must go hand in hand with some tightening of financial conditions. However, a sharp tightening of global financial conditions could have unintended consequences. An ever sharper rise in real interest rates could ultimately lead to a disruptive price appreciation and an even more pronounced stock market crash. As financial risks remain high in several sectors, monetary authorities should provide clear guidance on their future policy direction to avoid unnecessary volatility and preserve financial stability.
Tobia Adriano he is financial advisor and director of the IMF’s money and capital markets department. He directs the work of the IMF on financial sector surveillance and capacity building, monetary and macroprudential policies, financial regulation, debt management and capital markets. Prior to joining the IMF, he was senior vice president of the Federal Reserve Bank of New York and deputy director of the research and statistics group. Mr. Adrian has taught at Princeton University and New York University and is the author of publications in economic and financial journals, including theAmerican business magazine and the Finance newspaper. His research focuses on the global consequences of the evolution of capital markets. He holds a doctorate from the Massachusetts Institute of Technology, a master’s degree from the London School of Economics, a bachelor’s degree from Goethe University in Frankfurt and a master’s degree from Paris-Dauphine University.
Nassira Abbas is Deputy Head of Division of the Surveillance and Analysis of Global Markets Division of the Money and Capital Markets Department and is one of the authors of the Global Financial Stability Report. Prior to joining the IMF, Nassira headed the market research and asset purchase programs division of the Directorate-General for Monetary Policy at the Banque de France, where he also held positions including Deputy Director of Major Banks Division, Senior Analyst financial markets and senior portfolio manager, and international economist. He also held the role of Principal Banking Analyst in the Risk Analysis and Stress Testing Unit of the European Banking Authority. He holds a Global Executive MBA and a Masters in Finance from the Institut de haute finance internationale and the Sorbonne University, and a Research Masters in Political Science and Economics from the École of Sciences Po Paris Research.