Last month, we noted that negative real rates have become unsustainably low, particularly in the context of much-improved growth prospects and peak global liquidity/monetary policy. Since then, real rates—nominal rates less inflation (which is typically represented by inflation expectations)—have begun to inflect higher. Understandably, we’re watching this space carefully because if real rates do climb, it will be, in our view, an important inflection point for a variety of assets.
U.S. real interest rates on the move (%)
References to inflection points typically incite spirited debate among investors. However, it’s worth highlighting the need to watch this space carefully, as opposed to proactively position for such an outcome—for the simple reason that there remain important risks to our view that real rates will continue to rise:
- Yield curve control (YCC): A spooked U.S. Federal Reserve (Fed) could choose to suppress nominal rates by using YCC at the front end (likely the two- to three-year section of the yield curve), which would likely suppress yields further out the curve somewhat. However, since the front end of the curve is still well behaved—so far—financial conditions haven’t been adversely affected and the U.S. dollar (USD) hasn’t materially appreciated. We suspect the Fed will first try to anchor the front end of the yield curve with more concrete forward guidance and avoid YCC for now. Crucially, even if the Fed tries to contain the rise in nominal rates, breakevens can fall faster than nominal rates, which will have the effect of pushing up real rates.
- Higher energy prices: This will likely push breakevens higher and thereby slow the rise in real rates—although an even faster rise in nominal rates could trump any increase in breakevens.
- Market distortions: It’s likely that the price discovery mechanism isn’t functioning as efficiently in the break-evens market since the Fed has ramped up its holdings of Treasury Inflation-Protected Securities to 20% of the entire market.¹ As such, it’s important to recognize that there may be a disconnect between true market-based expectations and what's actually being measured in break-even levels.
That said, it’s important to understand how higher real rates could affect risk assets.
Rising real interest rates—impact on equities
Higher nominal rates aren’t typically associated with weak stock market performance because they largely represent an improved growth outlook and generalized reflation. The same, however, can’t be said for real rates—research has shown that rising real rates are typically linked to weaker equity return.² We also see a strong negative correlation between real rates and forward price-to-earnings (P/E) multiples, which suggests a further rise in real rates could lead to P/E multiple contraction.
U.S. real interest rates vs. S&P 500 Index forward P/Es
Source: S&P Dow Jones Indices, Macrobond, Manulife Investment Management, as of March 1, 2021. P/E refers to price-to-earnings ratio. LHS refers to left-hand side; RHS refers to right-hand side. The gray area represents recession.
While rising real rates represent a general headwind against risk assets, we think it’s yet to hit a point that would spark a larger correction. At this point, we believe it’s too early to advocate taking risk off the table because of rising real rates alone.
For instance, the S&P 500 Index continues to trade within its 50-day moving average and it’s likely that we could see policy action in the coming days or weeks from several central banks, including the European Central Bank, Bank of Canada, and the Reserve Bank of Australia.
We are, however, mindful of three triggers that could make higher real rates more challenging for risk assets, which in fairness, seem closer to us now than they were even a month ago:
- A small increase in real rates isn’t in itself a trigger, but as the rise in real rates persists, each incremental move becomes more problematic for markets.
- Similarly, the equity market is more sensitive to sharp moves in real rates than slow and steady moves. This is a fact that’s probably not lost on the Fed, which is why we suspect that a slow rise in real rates that weakens the equity market, but doesn’t derail it, is insufficient to spur the central bank into action by itself.
- In our view, once real rates approach positive territory, the challenge begins. If we assume breakevens had peaked in the 2.00% to 2.50% range, then headwinds can only grow as U.S. 10 year nominal rises climb to 1.75% or higher. We’re not there yet. Crucially, if breakevens can break out of this range higher, the trigger on the 10 year is commensurately higher.
Implications for gold prices
While gold is often thought of as being helpful in a rising rates environment that reflects stronger inflation, the precious metal has an inverse relationship with real rates—gold prices typically fall when real rates are high or rising. This is because real rates generally imply that growth is rising faster than inflation expectations and, therefore, rendering inflation protection less appealing. The important takeaway here is that, even if inflation expectations were to rise, should nominal rates rise at a faster pace, then higher real rates will continue to pose as a headwind for gold.
Gold vs. U.S. 10-year real yield
Rising real interest rates and currencies
The USD typically strengthens as real rates rise and break-even levels fall. That said, we have yet to come across any concrete evidence that real rates matter more to the value of a currency than nominal rates. Broadly speaking, we remain wary of a countercyclical spike in USD strength in the coming months, particularly as we see signs of incremental policy divergence between the Fed and other major central banks. The Reserve Bank of Australia has doubled its quantitative easing purchases to contain yields;³ many members of the ECB noted that the central bank would be flexible on purchases ahead to address the rise in rates,⁴ and our interpretation of comments from Bank of Canada Governor Tiff Macklem is that he would prefer the market to keep rates in Canada lower than in the United States.⁵ Separately, Fed communication—until now—suggests that it’s nonplussed by higher rates. We suspect this policy divergence will increasingly be relevant to the currencies space and make it more difficult for the USD to weaken.
1 Bloomberg, Macrobond, Manulife Investment Management, as of March 1, 2021. 2 UBS, February 26, 2021. 3 “RBA Doubles Down in Defense of Yields Amid Global Bond Rebound,” Bloomberg, March 1, 2021. 4 “ECB to Show Whether Pledge to Cap Yields is More Than Just Talk,” Bloomberg, February 27, 2021. 5 “Bank of Canada governor indicates readiness to let economy run hot to include more people in recovery,” Financial Post, February 23, 2021.
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