For the past two years, Citi’s Matt King proved why he is one of the best strategists on Wall Street because while others were focusing on various B-grade fundamental and technical catalysts which came and went with little impact on markets, the Citi strategist steadfastly said that the only thing that matters was real rates… and he was right – as long as real interest rates were deeply negative – an outcome the Fed was clearly targeting with its monetary policy – the bid for all other risk assets (as well as commodities, gold, crypto and so on) would always be present.
In recent weeks others picked up on this theme, with Deutsche Bank’s FX strategist George Saravelos saying two weeks ago that “The Most Important Question For The Market Is Identifying The Driver Behind Record Low Negative Real Rates“, while One River CIO Eric Peters saying that according to the market, “A Scenario Of Sharply Rising Real Rates Is Untenable.”
Today, it’s the turn of one of our other favorite sellsider analysts, BofA CIO Michael Hartnett to grab the negative real rates torch, and write in his latest Flow Show that while the deeply negative real rates may be just what stock market bulls ordered, 10-year real rates are now at -4.6%, “a level which in the past 200 years that has been associated with panics, inflations, wars & depression, and a level today increasingly responsible for froth in crypto, commodities, and US stocks.”
Another sellside strategist who recently expounded on the unprecedented collapse in real interest rates, was DB’s Jim Reid, who earlier this week wrote that while regular readers know his view “that inflation will be structurally higher going forward and that for the rest of my career real yields will likely stay negative even if nominal yields climb… nothing could have prepared hims for 2021.”
But while real rates are indeed at levels that typically presage or coincide with historical calamities and crises, this time may indeed be different because although inflation is soaring – and on pace to match what we saw in the 1970s – and will likely be structurally higher going forward, Reid writes that because debt is so high, “history suggests that heavy financial repression will be necessary to manage this.”
In other words, any time real rates start moving higher, the Fed will have no choice but to intervene as the alternative would be a terminal crash across all risk assets.
Here, Jim Reid chimes in and says that another reason why real yields will stay negative “for the rest of my career” is because this has been the pattern whenever debt has spiked through history, as the smoothed series in Figure 1 shows.
And while that chart highlights the US here, it’s been the case for other developed countries over the last two centuries, or as Reid puts it, “somehow financial repression has ruled.” In the US, debt previously spiked after the Civil War, WWI and WWII. This latest climb had been steadier (but substantial) until Covid, which may explain why real yields have steadily but consistently declined. However, the economic response to Covid has been more akin to a war time response, with debt and spot real yields both spiking in opposite directions just like that seen around and after the wars discussed above.
Figure 2 shows that each of these previous debt spikes have coincided with spot inflation hitting around or above 20%, which puts the current 6.2% print into some perspective.
There is a reason why inflation has to spike to short circuit this process: traditionally it helps debt peak out and support a deleveraging trend. As Reid adds, in the future, “a big problem will occur if inflation normalizes as there will be a limit to how far negative real yields can go to help erode the debt burden unless real GDP growth explodes higher (unlikely) or if nominal yields go consistently negative in the US (very seemingly unwelcome).”
So, for example, if inflation quickly and consistently goes back to 2% then we will probably see 10 year US yields around or below 1% to maintain financial repression. This is unlikely to help the deleveraging process though but it will ease the rise in debt.
Those who have followed Reid’s work in recent years, are aware that his template to how all this plays, is to expect structurally high inflation in the decade(s) ahead, with nominal yields being higher, but not climbing as much as inflation, thus allowing real yields to stay negative, indeed unlike previous episodes when real rates collapsed in a sharp but brief correction.
Indeed, 2021 has been an extremely aggressive form of this but nowhere near as aggressive as what was seen in the previous debt spikes seem in the next two charts.
The next chart shows nominal yields minus nominal GDP growth. Ultimately this has a bigger impact on how debt/GDP evolves as it adds the denominator to the equation. We’re still in a covid state of flux but clearly on a spot basis the US is running at -8% on this measure at the moment, which is around the lowest since the early 1950s. So good news for debt management.
Finally, the last chart shows the real Fed Funds rate back to 1921 using 3-month T-bills before 1954. No surprise here either that on this basis we have the most accommodative policy since the1950s. Indeed the only time it’s been lower is in the decade around the start of WWII.
So US real yields are currently very low at the front and back end, although they’ve been lower still when debt suddenly increased before. However that was with 20% inflation. Meanwhile, without financial repression – i.e., without the Fed manipulating rates to be artificially depressed through constant backstops – real yields would likely be consistently positive given the weight of debt supply.
But given the record global debt pile, that would strongly increase the probability of debt crises across the world. So while the baseline is continued indefinite financial repression, the risk is that something happens in the years ahead that prevents the authorities using financial repression.
If this occurs then, as Jim Reid warns, “the global financial crisis may look like a dress rehearsal for a much bigger event.”
All the reports mentioned here are available for professional subscribers in the usual place.