The Big Idea

Diagnosing the rise in longer rates

| September 29, 2023

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

Longer US yields have reached levels not seen since before the Global Financial Crisis, with most of the move coming from higher real rates. But major factors influencing real rates, trend growth above all, look materially different today than they did before the GFC. It is hard to make the case for longer real rates to hold at current levels. They look more likely than not to fall, bringing longer nominal rates with them.

Nominal rates follow real rates

Almost all of the rise in longer nominal interest rates this year has come not from higher inflation expectations but from higher real rates. Take US 10-year rates, for example. From an April 6 low on the 10-year of 3.31%, 10-year breakeven inflation has moved up by 10 bp while the 10-year real rate has moved up by 120 bp (Exhibit 1). Inflation implied either by the TIPS market or by surveys of economists has stayed around 2%. The big move has come from real rates. And real rates again will likely determine the next big move.

Exhibit 1: Steady breakeven inflation this year, rising real US 10-year rates

Source: Bloomberg, Santander US Capital Markets

To add some context, longer real rates have moved up in other global markets this year, too, but not by as much as the US. The 10-year real rate in Germany since April 6 has moved up by 67 bp, for example, slightly over half the US move (Exhibit 2). So the move to higher real rates in the US reflects a global component but also reflects influences distinct to the US.

Exhibit 2: Steady breakeven inflation, rising real German 10-year rates

Source: Bloomberg, Santander US Capital Markets

The current 10-year real rate also stands in sharp contrast to the real 10-year rate of pre-Covid years and close to pre-GFC years (Exhibit 3). Pre-Covid and pre-GFC levels are useful benchmarks for figuring out whether current real 10-year rates are sustainable at the current 226 bp.

Exhibit 3: US 10-year real rates approach pre-GFC levels

Source: Bloomberg, Santander US Capital Markets

Pulling apart the influences on real rates

In the abstract, the real rate is the price where supply and demand for money clears or, slightly less abstract, where the supply and demand for savings come into balance. That leaves the debate about the direction of the real rates open to anything that might influence US and global savings and investment. The list is long, but the debate broadly revolves around a handful of factors, some of them overlapping:

  • Trend growth. Slower growth should lower the demand for savings and bring down the real rate, all else equal, and faster growth should do the opposite. A range of studies show slowing trend growth for most of the last four decades across Western economies, with trend growth in the US before the GFC around 3% and after the GFC around 2%. The Fed currently sees trend growth still around 2%.
  • Population age. People tend to save into middle age and then stop and draw down assets in retirement. The median global age is around 30, according to the United Nations, and the median US age is around 37, implying rising savings and falling real rates.
  • A global savings. A rise in savings in Asia and the Middle East in the 2000s arguably contributed to lower rates in the US, partly because the savings came paired with rising demand for safe and liquid assets. Ben Bernanke famously called this the global savings glut. It’s harder to point to the same savings glut since the GFC.
  • Demand to invest. Some analysts have looked at the decline in real interest rates and pointed out that global investment as a share of GDP has run around 25% since the 1950s. If global savings have gone up and investment share has stayed the same, that only happens if demand to invest—and the demand for loanable funds—has gone down.
  • A grab bag of other factors.
    • US spending. Rising US debt as a share of GDP represents demand for funds and should push real rates up; the Congressional Budget Office projects US debt as a share of GDP will rise over the next decade from the current 98% of GDP to 115% of GDP.
    • Term premiums. The premiums for bearing interest rate risk have declined since the GFC, especially with Fed QE and with new rules requiring banks to hold liquid assets. This has brought Fed and bank funds into the market, lowering the real rate. But QT should start to reverse some of the impact on term premiums.
    • The 2020 pandemic. Both the GFC and the pandemic slowed growth and created uncertainty, reducing demand to invest and lowering real rates. As the economy comes out of the pandemic and growth returns, real rates should rebound.

Higher than pre-Covid

Quantifying the joint impact of all these factors on longer real rates is a tall order. But a simpler and still useful approach might ask how these factors have changed from pre-Covid levels and, consequently, how the real 10-year rate might differ from the pre-Covid real 10-year rate.

Some of the big things in today’s market arguably have not materially changed. Those include trend growth, global population age, the impact of global savings and demand to invest. These things argue for real 10-year rates roughly around pre-Covid levels.

But other things have changed. US spending as a share of GDP is rising much faster post- than pre-Covid. Term premiums should rise with the end of QE and the continuation of QT. Coming out of the 2020 pandemic should raise demand for money and investment, although the Fed is doing its job slowing that growth impulse. The things that have changed argue for a real rate higher than pre-Covid levels.

From the start of 2011 through 2019, the real 10-year rate averaged 31 bp with a high of 138 bp and a low of -92 bp. These levels work as lower bounds

But lower than pre-GFC

It also seems reasonable to ask how current circumstance might compare to a world where policy arguably was neutral and central banks played a smaller role. Compared to pre-GFC, say, 2004 through 2007 when the Fed was normalizing policy, some major factors today have changed. Perhaps most importantly, trend growth is a full 1% lower. Global savings arguably have dropped from pre-GFC levels, but not by enough to offset more than a small fraction of the drop in trend growth.

Some minor factors also differ today from pre-GFC years. US debt as a share of GDP is projected to go much higher over the next 10 years. But term premiums should stay lower under the influence of QT and bank liquidity rules.

It seems fair that the real 10-year rate going forward should fall below pre-GFC markets. From the start of 2004 through 2007, the real 10-year rate averaged 205 bp with a high of 282 bp and a low of 133 bp. Those levels should mark and upper bound.

Current 10-year real rates fall out of bounds

If the guardrails for the real 10-year rate fall between pre-Covid 0.31% and pre-GFC 2.05%, then the current real 10-year rate of 2.26% is just out of bounds. The 10-year real rate should fall below 2.05% and likely go much lower. The 10-year note consequently looks like good value at current yields.

* * *

The view in rates

OIS forward rates now see less than a 50% chance of another hike from the Fed and roughly steady rates through March. The same forwards then anticipate 78 bp of cuts from March to December 2024. This picture has changed very little over the last month. The risk to the market is that sticky inflation keeps the Fed at higher rates for even longer than expected, which would eventually create credit problems for balance sheets funded at floating rates that already are burning cash.

Other key market levels:

  • Fed RRP balances closed Friday at $1.56 trillion, up $130 billion in the last week but down dramatically from its March peak of $2.37 trillion.
  • Setting on 3-month term SOFR traded Friday at 540 bp, roughly unchanged in the last week
  • Further out the curve, the 2-year note closed Friday at 5.04%, down 7 bp on the week. Given the likely Fed path, fair value on the 2-year note is above 5.00%. The 10-year note closed at 4.57%, up 14 bp in the last week. At that yield, the 10-year note looks compelling. Yields should decline toward 4.0% or lower.
  • The Treasury yield curve closed Friday afternoon with 2s10s at -47, steeper by 20 bp in the last week. The 5s30s closed Friday at 9 bp, steeper by 12 bp in the last week.
  • Breakeven 10-year inflation traded Friday at 234 bp, down by 3 bp on the week. The 10-year real rate finished the week at 226 bp, up 20 bp on the week.

The view in spreads

The Bloomberg investment grade cash corporate bond index OAS closed Friday at 151 bp, wider by 8 bp on the week. Nominal par 30-year MBS spreads to the blend of 5- and 10-year Treasury yields traded Friday at 177 bp, wider by 10 bp on the week. Par 30-year MBS TOAS closed Friday at 72 bp, wider by 7 bp in the last week. Both nominal and option-adjusted spreads on MBS have been particularly volatile since June but trending wider.

The view in credit

Most investment grade corporate and most consumer balance sheets look relatively well protected against the likely impact of Fed tightening. Fixed-rate funding largely blunts the impact of higher rates on both those corporate and consumer balance sheets, and healthy stocks of cash and liquid assets allow these balance sheets to absorb a moderate squeeze on income. But other parts of the market funded with floating debt look vulnerable. Leveraged and middle market balance sheets are vulnerable, especially with the tightening of bank credit in the wake of SVB. At this point, mainly ‘B’ and ‘B-‘ loans show clear signs of cash burn. Commercial office real estate looks weak along with its mortgage debt. Credit backing public securities is showing more stress than comparable credit on bank balance sheets. As for the consumer, subprime auto borrowers, among others, are starting to show some cracks with delinquencies rising quickly. The resumption of payments on government student loans in September should add to consumer credit pressure.

Steven Abrahams
1 (646) 776-7864

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