Should real interest rates be even lower in the long run?

One of the key drivers of returns on financial markets are real interest rates. Most investors look at nominal interest rates as a guide to what they can earn by investing in money market funds or bonds. But really, what matters are real interest rates after inflation is taken into account. And as most interested investors know, the problem with real interest rates is that they have been negative in many developed countries for several years. This in turn means that by investing in inflation-linked bonds or nominal bonds you have to expect to lose money after inflation.

On the other hand, negative real rates are great for stocks since losing money with bonds means that more money is invested in stock markets driving prices higher. And this is where many investors get concerned about the future. If real interest rates were to rise structurally (i.e. beyond the cyclical recovery we have to expect as the economy comes out of the current recession) it could seriously hurt bond prices and equity markets at the same time.

And real interest rates are clearly at extremely low levels in developed countries as the chart below for the United States and 12 other developed markets shows.

Real interest rates in 13 developed countries (Left: Short-term rates, right: long-term rates)

Source: Kiley (2020). Note: Blue area indicates the range of 13 largest developed countries. Black line denotes the USA.

One of the main fear factors for investors who are afraid that low real rates cannot persist for much longer is demographic change. In theory, if populations age, dependency ratios increase, i.e. fewer active workers have to pay for the pensions of more retired people. This cannot be sustained at current levels forever and as a result, savings ratios for older people should decrease since older people have to tap into their private savings to make up for a shortfall of pension income. And lower savings ratios mean that interest rates should rise to attract the fewer savings available for investments.

The problem is just that if you test the relationship between dependency ratios and demographic change on the one hand and real interest rates, on the other hand, the sign comes out wrong. A higher dependency ratio and an ageing society leads to higher savings ratios and lower interest rates – the opposite of what models predict. This has again been nicely shown in a new study by Michael Kiley from the Federal Reserve Board. 

I have written in the past that we are observing a declining consumption to wealth ratio (which is to say a rising savings ratio) despite the fact that our population ages. Or because of it? Because one factor that tends to get forgotten is that with the increase in dependency ratio comes an increase in life expectancy and as people expect to live longer, they should start to save more and keep their savings ratio high even in retirement because their savings have to last longer. This factor alone predicts a declining real interest rate for another decade or so.

But Kiley shows that there is another factor at work: globalisation. As the world becomes more integrated and investors in emerging markets can move their capital freely to developed markets and vice versa, capital goes to work where it can get the best return. But that also means that investors can move their capital to wherever they can find the most attractive safe assets as well. If short-term Gilts in the UK pay a bit more interest than short-term bonds in the Eurozone, savings move from the Eurozone to the UK, etc. These flows may not be a lot since there is currency risk involved, but they suffice to link short-term interest rates across countries.

Now add an increasingly wealthy group of people in emerging markets who have more and more savings, some of which they want to keep in a safe haven. So that money flows to the United States, Europe, etc., and depresses interest rates there. The global savings glut overwhelms any effects demographic changes may have on interest rates and lead to the opposite outcome of what fearmongers about ageing populations may say. As I have said before, investing based on demographic changes is a really bad way to make money.

In fact, the analysis of Kiley shows something important: we can no longer model real interest rates on a country-by-country basis. We have to take global trends and interlinkages into account because these are today the dominant forces driving real interest rates. The chart below shows the real interest rate in the United States in blue together with the equilibrium rate in a US-only model (red dashed line) and the equilibrium rate in a global model (black dashed line). 

Real interest rates in the United States and where they should be

Source: Kiley (2020). Note: Blue line = real interest rates in the US. Red dashed line = equilibrium rate in a US-only model. Black dashed line = equilibrium rate in a global model.

The global model overall works better than the US-only model for predicting long-term equilibrium rates and it indicates that real interest rates in the United States should, in the long run, be around -1% - and that is pretty much where 10-year real rates in the United States are today. Yes, real rates will likely rise in 2021 as the economy strengthens, but don’t expect real rates to remain higher for longer. In a globalised world, negative real rates are here to stay.