Real uncertainty

R-star

Real bond yields remain deep in negative territory.  Real yields that we can observe – such as those on US Treasury Inflation Protected Securities (TIPS) – are the closest market approximation to the neutral real rate of interest (what economists refer to as r*). That in itself is not observable but there is a huge amount of literature about it and it is important in discussions over long-term potential economic growth and the effectiveness of monetary policy. For markets, a negative real yield is also important as it is a determining factor in the nominal valuation of all financial assets. The real yield plus inflation expectations plus risk premiums on credit and equity assets determines prospective returns. The current level of the yield on the US Treasury inflation linked 10-year bond is -1.0%.

Low returns

Negative real yields mean low nominal risk-free bond yields, even if inflationary expectations have risen this year. Corporate bond risk premiums (spreads) are at very low levels and even if equity risk premiums have gone up relative to bond yields, the absolute yield on equities is still low by historical standards. The inverse of the equity earnings yield is the price-earnings ratio which, in the case of most developed markets, is at its highest level compared to the range of the last 15 years. This means that across financial assets, prospective returns are low. An adjustment higher in real yields would be painful in the short-term but is necessary if future returns are to look more attractive.

Influences

If observed real yields do act as a proxy for the neutral real interest rate it is important to understand what drives that. Economists and central bankers ague that monetary policy itself cannot determine directly the real neutral rate. Instead, it is determined by potential long-term economic growth, demographics and other factors that might impact on levels of desired investment and desired savings. A speech delivered by Philip Lane, Chief Economist of the ECB, in November 2019 outlines these influences in a relatively non-technical way (see here). He suggests, as do many others, that trend potential growth in developed economies has declined in recent decades. There is also general agreement that ageing populations and slower growth in the labour force has contributed to lower productivity growth and a shift in desired levels of savings relative to investment. These have pushed the r* rate down. Empirically it is difficult to provide evidence on something that can’t be observed (don’t you just love economics?) but all of this makes conceptual sense.

Demand for safe assets

These are slow moving influences and one could argue that they won’t reverse quickly. Lane also hints at changes in asset preferences driven by demographics and policy. People are living longer into retirement and need a bigger pool of savings and high quality assets. Both monetary policy and regulation have increased the demand for risk-free sovereign bonds. There has been a role for global reserve accumulation as well, although it is not clear how strong that has been recently given the decline in China’s balance of payments surplus.

Climate change poses significant economic risks 

The effects of climate change and attempts to mitigate it should be factored into long-run economic expectations. Even though there are more and more commitments to reduce carbon emissions and thus limit the rise in global temperatures, there remains a significant risk that climate change is already so advanced that it will impact on the economy and society in big ways. A Swedish Riksbank paper discusses the link between climate change, the impact it can have on the economy and real interest rates (see here).

Physical and transition risks

Investors building portfolios that are less exposed to carbon and to the effects of climate change are increasingly considering physical risks to assets and business (flooding, rising sea levels, health effects from heat events and the potential disruption of ecosystems). They also have to account for transition costs by thinking about carbon pricing, regulation, the cost of investing in new technology, exiting from operations and changing consumer trends. These can have aggregate macroeconomic costs as well..

Higher C02, lower real yields?

It is not difficult to see how climate change leads to weaker future economic growth. Could it be that these risks are already factored into real rates today? The Riskbank argues that climate change creates uncertainty. We don’t know whether human policy actions will be able to control climate change and the worst effects of it. That uncertainty can impact economic behaviour (less investment and more precautionary savings). An additional point, which I find interesting, is that economic agents react to shocks and disasters (defined as something that causes a sharp drop in economic output) and this can lead to higher savings and lower investment. Climate change might mean that there are more frequent disasters (weather events) and this could already be influencing expectations and savings behaviour in the aggregate.

Shocks

Within the last generation, the world has experienced two major shocks. First the global financial crisis and then the COVID-19 pandemic. Both led to sharp drops in output and both changed behaviours – either forced by regulation or by choice, driven by increased fear of additional shocks. If climate change potentially means lower growth, more uncertainty and the risk of more frequent shocks then it can be an influence on real interest rates today.

Uncertainty principle

Bond yields are low and many investors and commentators think they are at the wrong level, given strong growth and rising inflation. Obviously monetary policy plays a role. But maybe this “uncertainty principle” does as well. COVID was a shock and continues to be a danger. The risk is that it can continue to play a negative role in setting expectations, influencing more risk-averse consumers and businesses. Precautionary savings might remain high until there is much more certainty that COVID has been eradicated, and we are not at that point yet. This supports my general view that nominal bond yields can’t rise that much, unless inflation provides an upside surprise to the current consensus of it being temporary.

Step up mitigation

If we accept that the risks from climate change do impact on future economic growth expectations and generate uncertainty, the question is what can be done? Governments need to be more aggressive in setting out climate change mitigation policies and using fiscal policy to invest in technologies to meet those goals. If the private sector’s desired investment levels are too low, then the public sector needs to step up by investing itself (deficits and borrowing) or by changing the economics to make private businesses invest (carbon taxes). By doing more now, there may be less uncertainty about the future. Moreover, increasing policy action now can actually lead to higher potential economic growth through the development and diffusion of new technologies and reductions in risks associated with climate change.

Real yields can go higher if central banks tighten monetary policy. We saw that in 2018. However, reversing the long-term decline in the real interest rate requires a shift in the savings-investment balance that reflects a more optimistic economic future. If there is no real evidence of that, investors should buy bonds when there is a rise in yields. In that case, don’t fear the Fed raising rates – buy the long-end when they do.