One reasonable target by early next year would be a return to a positive ex-post real rate, that is to say, a 10-year yield that exceeds year-over-year core CPI inflation.
From a simple micro-economic perspective, in normal times, real interest rates should always be positive. Someone who saves, rather than consumes, should demand a positive reward in real terms or else why would they save? Someone who borrows to invest should expect a positive real return on their investment or else why would they go to the trouble of borrowing? And, expecting a positive real return on their investment they should be willing to pay a positive real rate of interest to their creditors.
Real rates did turn negative in periods in the late 1970s and early 1980s when investors were convinced that inflation, while high, was very likely to fall sharply. However, that is not the case today so there are really only two broad reasons for the existence of negative real rates. One is that income and wealth have become so concentrated that there is a surplus of funds to be invested relative to those who are willing and able to borrow. A second is that central banks, including the Fed, have massively intervened in the bond market, pushing long yields down.
However, it should be noted that both of these forces could recede going forward. The Biden Rescue plan, while a powerful stimulant to the economy, is also tilted towards lower income Americans, while the taxes to fund today’s huge deficits will likely eventually come from the pockets of the rich. In addition, despite the Fed’s current dovish tone, it could well taper bond purchases in early 2022 if, by the end 2021, growth is stronger, unemployment is lower and inflation is higher than the Fed currently projects. In short, by the first quarter of 2022, we expect year-over-year core CPI inflation to be between 2.0% and 2.5% and, barring some economic setback, 10-year Treasury yields could be in a similar range.
Finally, what does this mean for equities?
History suggests that rising rates, from low levels, don’t pose a significant threat to stocks. Indeed, since 1963, an increase in the 10-year yield, when it has been below 5%, has normally been associated with a rising stock market while increases in yields from a higher starting point have generally accompanied falling stock prices.
While the precise 5% threshold suggested by history is likely untrustworthy, the theoretical point still makes sense. If interest rates are rising because of economic recovery, then stocks do well. If interest rates are rising because the economy is too hot and the Federal Reserve is trying to cool it down, then stocks do poorly. In the winter of 2021, we are still clearly in the first of these paradigms. However, investors should maintain a close watch on our success in battling the pandemic, the extent of fiscal stimulus and the pace of economic acceleration to make sure they are not caught flat-footed if a long-supportive bond market finally turns less friendly.
David Kelly is chief global strategist at JPMorgan Funds.