Be “real” – where do we go now?

In the U.S., interest rates have hit all-time lows across much of the yield curve. As an interest rate hedging advisor, clients tend to look to Chatham for views and outlook on interest rates. My usual refrain is informed by the wisdom of the author Fred Schwed, in his satirically titled “Where Are the Customers’ Yachts?” (1940): “For one thing, customers have an unfortunate habit of asking about the financial future. Now if you do someone the signal honor of asking him a difficult question, you may be assured that you will get a detailed answer. Rarely will it be the most difficult of all answers - ‘I don't know’.” Even the market’s expectations tend to be wrong. Instead, it is more useful to focus on creating a framework for the management of interest rate risk.

Interest rates in context: a possible framework

The future is uncertain. Just because the future is unknown, it does not preclude one from having a framework for thinking about interest rates.

Real interest rates vs. nominal interest rates

A simple matrix I came across years ago, while investigating inflation protected securities, illustrates the relationship between interest rates and inflation in different macro conditions.

Note the column headers are “real rates”, which unfortunately are not the rates on which borrowers focus. These are “nominal rates”. Fortunately, there is a relationship between real rates and nominal rates which is the level of expected inflation. The arithmetic tells us that real rates + inflation compensation = nominal yields. With any two of the three components we can solve for the missing value. Further, we can observe both nominal and real yields in the U.S. Treasury market with the difference being what is called “breakeven” inflation, or effectively the inflation compensation inherent in the nominal rate.

Real rates are an important variable on which to focus as the Federal Reserve is fundamentally concerned about price stability as a primary objective. The Fed’s position is to specifically target, or anchor inflation at a positive level around 2%, perhaps even allowing inflation to overshoot this target to make-up for periods where inflation has undershot – “average inflation targeting”. If the Fed wants to stimulate inflation, they will engage in “expansionary” policies, such as cutting their target rate, purchasing assets (quantitative easing) and managing expectations around the future path of policy (forward guidance), or attempt to cap certain nominal yields at a specific level (yield curve control).

If a stated objective of the Fed is to achieve an inflation goal, how can one use the framework above to inform their view of nominal rates? The real rate is often defined by a theory called money neutrality, which broadly states that changes in the money supply (controlled by the Fed) do not directly impact the economy’s long-term ability to produce goods and services, as those factors are directly tied to real things like the economy’s natural resources, labor stock, and capital. The real rate of interest should be a function of the fundamental supply and demand of capital between savings and investment, where desired capital for savings are positively correlated with the level of real rates, and desired capital for investment are negatively correlated with the level of real interest rates. The real rate is the rate that leads savings to equal investment, and while we cannot observe this rate directly, we can approximate it as discussed above.

One thing is clear – real rates are currently very low. In the U.S., the TIPS (real) curve is currently showing a negative yield out to 30 years. While not exhaustive, there are two main theories explaining the fall of real rates experienced over the last several decades. One is that the collapse in real yields is driven by falling demand for capital. This is Larry Summers’ “Secular Stagnation”. Summers’ theory broadly posits that the U.S. can no longer simultaneously achieve growth, capacity utilization, and financial stability and as a consequence real rates will remain low (see Summer’s NABE writing).

Of course, the supply of capital can shift as well, and so the competing theory, as postulated by former Fed Chairman Ben Bernanke and his writings on what he called the “global savings glut”, can also be informative. Bernanke concluded that “global excess of desired saving over desired investment, emanating in large part from China and other Asian emerging market economies and oil producers like Saudi Arabia, was a major reason for low global interest rates.” (see Bernanke’s April 2015 post on the topic).

Additionally, both curves could also move at same time. Perhaps households will save more if they view the economy as being less productive, as lower productivity calls into question their future earnings from their labor capital, and vice versa.

For most of our clients, their biggest concern is an increase in nominal interest rates, as this will either increase future debt service or decrease the value of fixed income investments. With that in mind, what could drive nominal rates higher based on the quadrants above?

• Clearly an increase in real rates with a corresponding increase in inflation would lead to an increase in nominal yields – the bottom-right quadrant in the table above. This would seem to be most likely to occur with an FOMC policy that keeps inflation running “hot” while productivity and growth increases, perhaps with the help of fiscal stimulus to boost demand and sustain growth. This can lead to a cycle of foreign capital being withdrawn as the value of the dollar is deteriorating in the face of sustained inflation. This can lead to an increase in nominal yields as foreign capital does not fund USD investment and consumption. There are some recent articles about the demise of the U.S. dollar’s reserve currency status, which may also go hand-in-hand with some writings on Modern Monetary Theory and the Federal Reserve monetizing the Federal deficit, and are all wrapped up in a debate over future inflation.
• Secondly, an increase in real rates without a corresponding decrease in expected inflation would lead to an increase in nominal yields, the top-right quadrant in the table above. This would seem to be most likely with a productivity boom. The caveat here is that if inflation expectations are declining during this time, then nominal yields may not increase even as real rates are increasing. How could inflation be decreasing with productivity, leading to increased demand for capital increasing? One possible answer is that the Fed is effective at controlling inflation through policy. Another is that the productivity improvements (say from technology) leads to declining labor demand and keeps wage increases at bay, limiting inflationary pressures.
• The lower-left quadrant in the table above is the other that could see an increase in nominal rates. However, it is not conclusive as to whether nominal yields would rise in this quadrant. This type of stagflation scenario could be driven by something like a supply chain shock driving up the price of goods and services while real economic growth remains stalled. The oil embargo of the 1970s is a commonly cited example, and more recently there is talk of “onshoring” that could lead to increased prices without corresponding economic growth.

Defining productivity

You will notice “productivity” mentioned a few times in the preceding discussion, so it might be helpful to define productivity. A general definition of productivity is output per unit of labor or per unit of capital, or some average of the two. Why the concern with productivity? As economist Paul Krugman said in his book The Age of Diminished Expectations: “Productivity isn’t everything, but in the long run it is almost everything”.

Credit spreads

For our clients, there is one aspect of nominal rates that we have yet to consider – the credit spread, or compensation for risk above and beyond the nominal risk-free rate. Again, investors are generally concerned with their all-in nominal yields (all-in coupon), so it’s necessary to consider what can cause these spreads to increase or decrease, and their correlation with changes in the nominal rates in the four quadrants we explored above. Credit spread risk could very well be issuer-specific, but it would still seem fair to generalize that an increased risk of default should lead to higher spreads. A negative economic shock that decreases the likelihood of borrowers’ ability to service debt likely results in credit spreads widening, while at the same time, nominal risk-free rates could be falling. This scenario played out during March 2020, rendering all-in risk rates marginally increasing, or little changed, despite declining risk-free rates.

It would also seem feasible that in the stagflation scenario (bottom-left quadrant) there is a decent likelihood that spreads would widen as growth and productivity stall. There is a good bit of uncertainty around the interplay of risk-free nominal rates and credit spreads, leaving it to depend on the specific circumstances that have moved rates amongst the four quadrants. Further, the Fed, in conjunction with the U.S. Treasury, has engaged in programs that suppress such credit spreads by engaging in programs that buy risky and less/liquid assets which have included MBS (mortgage backed securities) and more recently certain corporate bonds.

We can broadly generalize that risk-free nominal yields will be rising in a scenario with rising real rates and rising inflation, and that risk-free nominal yields will be falling in a scenario where real yields and inflation expectations are both falling. However, in none of the quadrants can the investor be assured how the all-in yield of a “risky” investment might change, as that would require knowledge of the relative rate of change in rates and spreads. It seems likely that the bottom-left quadrant, which is broadly stagflation, is likely the worst case for those concerned with widening all-in yields (especially so if the assets owned by that investor are insensitive to inflation).

While the focus above has been on the risk borrowers face to rising interest rates, it would be remiss not to mention that falling and negative interest rates may also give rise to risk.

I do not know what the future holds, but I do think we can likely say that currently we are in the upper-left quadrant of the table (low inflation, both realized and expected, and low real yields). Why? Because the market tells us it is so – the 5-year U.S. Treasury nominal yield is 0.27%, and the 5-year TIPS yield is -1.11%, implying a 5-year breakeven inflation rate of just 1.38%, not exactly scorching hot inflation expectations. The 10-year breakeven inflation rate is not much higher at 1.50%. Both of these sit below the Fed Reserve’s 2% target.

Risk frameworks

What is risk? Thomas S. Coleman’s “A Practical Guide to Risk Management” defines as follows: “Risk is the possibility of P&L being different from what is expected or anticipated; risk is uncertainty or randomness measured by the distribution of future P&L.” It follows that the goal of risk management should be to maintain earnings within an acceptable range of outcomes to the best extent possible. As with the discussion of interest rates, there is a wealth of literature on risk and risk management, and common to most is the concept that risk management is an organizational process that generally involves some or all of the following attributes:

• Identifying organizational or investment objectives
• Identifying known risks
• Attempting to measure, report, and monitor identified risks
• Attempting to uncover unknown risks – those not experienced in the past
• Selecting a risk tolerance threshold
• Selecting a response to manage exposure to risks
• Continuous control and monitoring of risks

It is unlikely all unwanted or unanticipated risk can be identified and managed to an acceptable level, so perhaps it is also worth considering taking some level of precaution against repeated exposure to events that could lead to ruin, such as tail risk (low probability events to which repeated exposures may ultimately lead to disastrous losses). Avoiding situations where the downside of a mistake is high seems prudent, especially situations where the reward to taking on such risk might, in hindsight, only be modest.

With the Fed seemingly pledging to keep short-term rates pinned to the zero lower bound for an extended period of time (some think five to ten years), the possibility that nominal rates are targeted by the Fed either through forward guidance, QE programs which keep rates suppressed, and policies allowing inflation to “run-hot”, it would seem unlikely that both real yields and nominal yields are poised to move much higher in the near-term; perhaps leaving us in the top-left quadrant for a long time. Looking at measures of implied interest rate volatility (like the ICE BofA MOVE Index), we are at or near record lows, implying investors do not believe there is much risk of rates moving much anytime soon. It might prove wise to heed the warnings of economist Kenneth Arrow: “Vast ills have followed a belief in certainty.”

One risk that I see is inherent in the wisdom of Arrow: a general level of complacency around interest rate risk takes hold and firms let their guards down, deviate from their policies, falling prey to the human tendency to believe in certainty and fall into behavioral biases that drive their decision making. Despite the Fed providing indications of how they will proceed with policy from here in the face of the pandemic, one can certainly ponder a number of scenarios that could lead to potential higher nominal rates in a time frame that is not anticipated. These would not be black swans, but may certainly be characterized as “low probability” in light of the current environment. For example, what if a vaccine is found sooner or is more effective than anticipated? What if another technological breakthrough revolutionizes the world in the way the printing press once did, or the internet has done? What if tensions with China escalate further in a way that impacts inflation or the role of the dollar in the global economy? “What if” can be a useful exercise to incorporate into the risk management framework above.

Despite the rhetoric of the Fed, inherent uncertainty remains in the world today. Economist and former Fed Vice Chairman, Alan Blinder, wrote back in 2010, when the Fed was first embarking on its quantitative easing strategies, the following (with some paraphrasing): the Fed finds itself on an alien planet, with a near zero funds rate and a $10 trillion dollar balance sheet, including a variety of “dodgy” assets and continued pressure to act in conjunction with the Treasury, the implications of which are unknown and the exit from such policies seemingly further uncertain both in terms of timing and impact. In such an environment it would seem prudent for investors to keep their guard up in the area of interest rate risk.

To borrow again from Fred Schwed: “In this case, the notion that the financial future is not predictable is just too unpleasant to be given any room at all in the Wall Streeter's consciousness.”

The purpose of this piece is not to provide the answers, but to attempt to provoke a new perspective of thinking around interest rates and risk management. Maybe you’ll decide that now is a good time to take advantage of relatively low volatility and buy “insurance” against some currently thought to be unlikely scenarios. Maybe you’ll decide the risk of inflation being materially higher in the future is a risk to be managed, or maybe you’ll find that your business/investments can absorb a significant move higher in rates from here. Certainly decision making is likely improved with a framework to consider the risk at hand.

How can Chatham help?

• Enhance your knowledge and understanding of the drivers of the current interest rate environment
• Keep you abreast of how specific conditions in the market are changing over time
• Identify and quantify risk exposures where possible
• Identify the appropriate tools and the associated cost of such tools that may be available to help you mitigate interest rate risk
• Optimize the deployment of the aforementioned tools

By incorporating a company’s risk tolerance profile, its confidence in its underlying borrowing needs, as well as its credit, regulatory, and liquidity constraints, Chatham can evaluate the company’s unique situation against peers and market best practices informing on terms, pricing, accounting treatment, and reporting.