By Ashwin Alankar, Ph.D.
Global Head of Asset Allocation Dr. Ashwin Alankar explains why real rates are behind recent bond and stock market volatility.
- While this week's volatile stock trading may have caught investors' attention, we consider it a continuation of the turbulence that has recently weighed on longer-dated bonds.
- We believe that a rise in real interest rates are behind these moves as investors raise their expectations for real yields, resetting the cost of capital across the economy.
- At present, we see no near-term acceleration in inflation, a development we attribute to the Fed staying ahead of the curve in guiding the economy out of loose monetary policy.
The early-month sell-off in global bonds spread to equity markets this week. While chatter has identified potential culprits ranging from trade concerns to rich valuations, our eye is squarely on real interest rates. We have long emphasized the important role that real rates would play during the Federal Reserve's (Fed) normalization program, as they are what ultimately determine investment decisions across the economy. While this week's equity move caught investors' attention, we believe the epicenter of the market's current rebalancing remains the bond market.
All About Real Rates
Using our proprietary options market-based model, we believe that calmer heads are prevailing as we see non-U.S. equities showing average to above-average levels of expected upside versus downside, suggesting that what we are dealing with today is more of a U.S.-centric event. Why? Because U.S.10-year real rates are moving up toward "tight" levels - rising 30 basis points (bps) in just over a month to 1.04% today. While higher, we wouldn't consider real rates approaching dangerous levels until they exceeded real GDP expectations of possibly the 1.5% to 2.0% range.
Such a scenario would pose a headwind to both risky and real assets, with many already becoming less cheap. This potentiality differs considerably from conditions in Japan and Europe where real rates still sit very accommodative - and in some instances, negative - levels.
The good news is that options prices do not suggest an imminent inflationary shock. Such an event would be a catalyst to cause the Fed to tighten more aggressively, withdrawing substantial liquidity from the economy. That could cause real rates to move higher faster, which would transform a Category 1 headwind to a Category 4 storm.
The End Of Easy Money
For these reasons, while this week's equities volatility has grabbed headlines, we believe the bond market's recent moves will likely have more meaningful long-term consequences. In a simple world, if real rates are below real GDP, monetary conditions can be considered accommodative, and money is "cheap." We can assume normalized real U.S. GDP to be in the range of 1.5% to 2.0%. In contrast, for roughly the past decade, real rates have been well below 1.5% and have even fallen to negative levels.
This, of course, was the result of the Fed's highly accommodative monetary policy. Now, however, real rates - at 1.0% - are finally approaching normalized real GDP and its impact will be meaningful as risk premiums will have to reprice in the new era of non-cheap money. The consequences of rates well below normalized GDP over the last 10 years were easy to see as the value of risky assets soared. The reverse will likely be true as real rates move toward more normal levels.
Rising For The Right Reasons
We believe that real rates are one of the most important determinants of future economic growth, as an increase would reset the cost of capital across the entire economy. Longer-duration assets, like growth stocks, would likely be most negatively impacted by higher real rates, as would real assets such as real estate and gold. Indeed, the numbers have borne this out, with growth stocks far underperforming value since the end of September.
While choppy markets merit vigilance, we believe the forces behind this week's volatility may herald some good news. Driving the uptick in real rates is the market gaining faith in the sustainability of U.S. economic strength. The current convergence of real yields toward higher real GDP growth rates indicate that bond market expectations are finally catching up with what the economy has been delivering for several quarters. But it also means the easy money that borrowers have gotten used to might be a thing of the past.
Ahead Of The Curve?
With real yields leading the charge, another ingredient to bond prices - inflation - noticeably isn't. Recent wage gains may have spooked investors that a breakout in inflation was on the horizon, but our options model shows no such risk. Historically, the Fed has been labeled as consistently being behind the curve in managing inflation. We believe this time is different.
Ever since the Fed started backing away from highly accommodative policy during the former Chairwoman Yellen's tenure, we thought that the central bank may actually be ahead of the game. When the Fed initially increased rates in December 2015, after all, core inflation as measured by the Fed's favored gauge was a paltry 1.3%.
Due to this proactive "tightening" campaign, inflation risk at present appears contained. This gives the Fed the very valuable luxury of increasing rates in a disciplined and calm fashion. Such a measured pace provides the economy - and allocators of capital more specifically - sufficient time to adjust to higher real rates. And as we have long stated, it is not the destination of interest rates, but the pace at which they travel, that is most important.
Signals From Options Markets
Yes, we interpret higher real rates as investors expressing a more sanguine view on the U.S. economy, but our options-market signals also have identified other factors that bear monitoring. Unlike February's short-lived volatility, options investors expect that this turbulence may be longer lasting. But here, too, that is not necessarily alarming. As higher real rates impact the cost of capital across the economy, economic outcomes should become more dispersed. We see this as part of the policy normalization process.
Expectations of more normalized economic and market conditions - and with them more volatility, brought on in part by a higher cost of capital, can be seen in options signaling potential weakness in small-cap stocks, strength in the "safe-haven" Japanese yen and upside to the volatility indices, which infer elevated equity risk. In aggregate, however, there is no pronounced downside evident in options price signals. Indeed, some areas - among them emerging markets - show greater potential upside than downside.
Normalization, painful or not, is ultimately good for the mechanisms underpinning the economy. Fortunately, we do not foresee any level of pain commensurate with a recession, and for this we give credit to the proactive stance taken by the Fed. Unfortunately, however, our same models see risk resetting at higher levels across many asset classes.
Note: Our Adaptive Multi-Asset Solutions Team arrives at its outlook using options market prices to infer expected tail gains (ETG) and expected tail losses (ETL) for each asset class. The ratio of these two (ETG/ETL) provides signals about the risk-adjusted attractiveness of each asset class.
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