Low Real Interest Rates Support Asset Prices, But Risks Rising for Market

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Nassira Abbas is deputy division chief in the Global Markets Monitoring and Analysis Division of the Monetary and Capital Markets Department at the International Monetary Fund (IMF). Tobias Adrian is the Financial Counselor and Director of the IMF’s Monetary and Capital Markets Department.
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Supply disruptions, coupled with strong demand for goods, rising wages and rising commodity prices, continue to challenge economies around the world, pushing inflation above targets. of the central bank.

To contain price pressures, many economies have begun to tighten monetary policy, leading to a sharp rise in nominal interest rates, with long-term bond yields often an indicator of investor sentiment. , recovering to pre-pandemic levels in some regions such as the United States. state

Investors often look beyond nominal rates and base their decisions on true rates, that is, rates adjusted for inflation, which help them determine the return on assets. Low real interest rates induce investors to take on more risk.

Despite somewhat tighter monetary conditions and the recent rally, long-term real rates remain deeply negative in many regions, supporting elevated prices for riskier assets. Further tightening may still be required to control inflation, but this puts asset prices at risk. More and more investors might decide to sell risky assets as they become less attractive.

different perspectives

While shorter-term market rates have risen since the aggressive move by central banks in advanced economies and some emerging markets, there is still a stark difference between political leaders’ expectations of how much your benchmark rates will go up and where investors wait for the hardening to finish.

This is most evident in the United States, where Federal Reserve Officials (of the Fed) project that its main interest rate will reach 2.5%. That’s more than half a point above what 10-year Treasury yields indicate.

This divergence between market and policymaker views on the most likely path for borrowing costs is significant because it means investors may adjust their expectations of the Fed tightening higher and faster.

Furthermore, central banks could tighten more than they currently anticipate due to persistent inflation. For the Fed, this means that the main interest rate at the end of the tightening cycle could exceed 2.5%.

Implications of the gap between rate and trajectory

The path of policy rates has important implications for financial markets and the economy. As a result of high inflation, real rates are historically low, despite the recent spike in nominal interest rates, and are expected to remain so. In the United States, long-term rates hover around zero, while short-term yields are deeply negative. In Germany and the UK, real rates remain extremely negative across all maturities.

Such low real interest rates reflect pessimism about economic growth in the coming years, global savings glut due to aging societies, and demand for safe assets amid heightened uncertainty exacerbated by the pandemic and recent geopolitical concerns. .

Record low real interest rates continue to buoy riskier assets, despite the recent rally. Low long-term real rates are associated with historically high price-to-earnings ratios in equity markets, as they are used to discount expected future earnings growth and cash flows. All things being equal, monetary policy tightening should trigger a real interest rate adjustment and lead to a higher discount rate, resulting in lower stock prices.

Despite the recent tightening of financial conditions and concerns about the virus and inflation, global asset valuations remain strained. In credit markets, spreads are also below pre-pandemic levels, despite a recent modest widening.

After a banner year supported by strong earnings, the US stock market started 2022 with a sharp drop amid high inflation, growth uncertainty and weaker earnings prospects. As a result, we expect that a sudden and substantial increase in real rates could cause a significant drop in US equities, particularly in highly valued sectors such as technology.

Already this year, the 10-year real yield has risen by almost half a percentage point. Equity volatility soared on increased investor nervousness, with the S&P 500 down more than 9% for the year and the Nasdaq Composite measure down 14%.

Impact on economic growth

Our growth-at-risk estimates, which link downside risks to future economic growth with macrofinancial conditions, could rise substantially if real rates rise suddenly and financial conditions more generally tighten. Favorable conditions helped governments, consumers and global businesses weather the pandemic, but this could be reversed as monetary policy tightens to curb inflation, tempering the economic expansion.

Also, capital flows to emerging markets could be at risk. Investments in stocks and bonds in those economies are generally considered less safe, and tightening global financial conditions may trigger capital outflows, especially for countries with weaker fundamentals.

Looking ahead, with persistent inflation, central banks face a balancing act. Meanwhile, real interest rates remain very low in many countries. The tightening of monetary policy must be accompanied by some tightening of financial conditions. But there could be unintended consequences if global financial conditions tighten substantially. A sudden higher rise in real interest rates could potentially lead to a disruptive price revaluation and an even bigger sell-off in equities. As financial vulnerabilities remain high in several sectors, monetary authorities need to provide clear guidance on future policy stance to avoid unnecessary volatility and safeguard financial stability.
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This article has been republished from blogs.imf.org.
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Learn more:
– Bitcoin, Ethereum, Stocks Drop as Fed Confirms Tapering Schedule
– Bitcoin in a rising interest rate environment

– How the global economy could affect Bitcoin, Ethereum and Crypto in 2022

– IMF warns of dangers of Fed rate hike, Brazil says inflation ‘will not be temporary in the West’
– Two main macro scenarios in play for Bitcoin and Crypto in 2022 – CryptoCompare

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