Now that inflation has increased and broadened, will long-term interest rates stay higher for longer? In this update, we explain why we believe rates could stay high and under what circumstances — our base case, in fact — rates could return to lower, pre-pandemic levels.
- The strong desire to save for the future has been the main factor keeping real interest rates low for decades.
- An increase in wealth reduces the desire to save and increases the desire to spend, and that is exactly what households have been doing since Covid-19 worries waned.
- If we are in a relatively higher-for-longer rates environment, the dominance of asset betas to interest rates in determining returns is likely to decrease, and active asset management can once again gain traction.
Determinants of long-term rates
In an economy with stable population dynamics, the long-term real interest rate moves along with the long-term growth rate. The steady-state interest rate is not necessarily equal to the potential growth rate. The composition of a population, along with the types of changes in tax and redistribution programs, can have strong influences on consumption, saving, and investment decisions. This can alter steady-state interest rates. The long-term interest rate should normally be higher than the long-maturity risk-free government bond yield, as economic growth is attained by taking risk. That is, a benchmark like the 10-year real U.S. Treasury rate should be lower than the long-run growth rate under normal circumstances.
As for population composition, from the late 1970s to the mid-2010s, the global working age demographic rose relative to children and people in old age. This shift brought global rates down because working-age people save for retirement. However, the influence of demographic factors on interest rates ceased in the mid-2010s as the baby boom generation started to retire.
The Covid-19 pandemic changed saving, spending, and wealth
The strong desire to save for the future has been the main factor keeping real interest rates low for decades. However, if people become confident that their future needs will be comfortably met, their willingness to save declines while their willingness to consume rises. This is how some Covid-era developments can influence interest rates. Large fiscal and monetary stimulus introduced in the early days of Covid along with lockdown savings, which are a direct consequence of reduced mobility, significantly increased household savings.
An increase in wealth reduces the desire to save and increases the desire to spend. Households have acted on such desires since Covid worries waned. The drop in the U.S. personal saving rate to historic lows is reflecting this. Elevated levels of wealth, especially relative to incomes, seem to have made households comfortable about their future needs. If the extra wealth lasts, the tendency to save less and consume more can continue, lifting the equilibrium interest rate.
Wealth rose in the Covid pandemic, and the saving rate fell to historic lows
Ratio of U.S. household net worth to personal income and U.S. saving rate
Sources: Federal Reserve Board and Bureau of Economic Analysis (data as of 12/31/22 for personal saving rate, and 9/30/22 for net worth/income ratio).
How rates could fall to pre-Covid levels
During 2023, it is possible households will continue to consume out of their excess savings that accumulated during the pandemic. It is also likely that asset values will decline more, eroding the value of wealth. In other words, it is possible that we go back to pre-Covid dynamics. This will extend the cycle, but it is necessary that aggregate net worth relative to income comes down for the long-term rate to fall. If the labor market remains strong, reducing the need for consuming out of savings, and if asset values do not fall because the market's Fed cut expectations stay high and/or global growth prospects rise, households will not need to retrench. Since the willingness to save would remain low in this case, the equilibrium interest rate would stay high.
The roles of monetary and fiscal policy
Monetary policy does not affect long-term interest rates. By decreasing or increasing the policy rate below or above the underlying equilibrium risk-free rate, central banks add or withdraw stimulus during an economic cycle. In the post-Covid world, if the Fed fails to see that the terminal interest rate — the policy rate compatible with the equilibrium interest rate — has risen and quickly cuts the policy rate along with market expectations (outside of a recession), inflation is likely to remain a problem. Inflation can come down but may not sustainably go back to 2%. The Fed may have to reverse course as the Volcker Fed did in the early 1980s.
As for government programs, only some have an impact on long-term growth or interest rates. Of these, unfunded government commitments to older adults, i.e., Social Security and Medicare obligations, will start to matter more in coming years. The U.S. government will have to issue debt for the first time to meet its obligations to retirees. This is a consequence of changing demographics, but it would not be an issue if the programs were funded. The U.S. government's higher funding needs may meet lower saving preferences. This combination would likely raise interest rates unless excess savings disappear.
Change will be gradual
The underlying interest rate might have risen a bit, but the new trend will take root only over time. The transition is unlikely to be quick or smooth. Investors will not easily give up the frameworks they have repeatedly used. We are likely to have many mean-reverting rallies, especially now that inflation is coming down and a recession is likely approaching.
Silver lining for active management
In a relatively higher-for-longer rates environment, the dominance of asset betas to interest rates in determining returns is likely to decrease. The decline in the risk-free rate has lifted all asset prices, especially the prices of assets with longer (empirical) duration. When the influence of rates in asset returns wanes, fundamental factors are likely to resurface. Dispersion in asset returns might rise, and security selection can matter more. When capital becomes more expensive, borrowers' quality and ability to generate cash flows and value are likely to matter more. At the firm level, this would discourage risky projects and investments. At the sovereign level, it would encourage fiscal discipline. Many risky companies and sovereigns that found access to cheap global liquidity may find it hard to do so going forward. That is, fundamentals might start to matter after all. If there is a silver lining to this low-return outlook, active asset management can once again gain traction.
As the year progresses, we will have a better idea if the imbalances are correcting. The base case of our Global Macro strategy remains that a recession will likely wipe out excess savings, so the relatively low interest-rate environment will return. However, 2023 started with rising asset valuations, supported by more Fed cut expectations. Declaring a victory too soon on a soft landing is unfortunately working against an eventual victory on reduced inflation and interest rates.
The views and opinions expressed are those of the Putnam Fixed Income Team, are subject to change with market conditions, and are not meant as investment advice.
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