Rising real interest rates do not pose a major threat to the performance of multi-asset portfolios, says Florian Ielpo of Lombard Odier Investment Managers.
The Fed has said it: it will normalize its monetary policy, and soon. The main reason is that growth prospects have improved sustainably. The improved economic environment implies a return to a neutral monetary policy stance. Inflation is not the problem: Inflationary forces are temporary, and the Fed is comfortable with 2.3% inflation in the long run. Some Fed members even think it is necessary to raise interest rates earlier than expected. As Florian Ielpo, Head of Macro at Lombard Odier Investment Managers (LOIM), continues, this session has thus signaled a rise in real rates, which depends on two key factors:
- Monetary policy: an accommodative monetary policy is usually accompanied by a decline in real interest rates.
- Unusually high savings lead to lower real interest rates.
"With growth prospects now more favorable, real rates are likely to rise as savings are partially spent and monetary policy is less accommodative", according to Ielpo. The following figure shows the development of real interest rates within one day from 20. up to 24. September. The FOMC has clearly changed the game (the bar in the chart), and real yields are now rising.
Intraday Changes in Real U.S. Interest Rates
Implications for financial markets
What impact does this have on the financial markets?? According to the expert, the recovery of real yields from negative territory is a rare situation that has occurred only three times since 1950. If you look at the history of available data after World War II, he says there have been three instances when real interest rates were negative and went back to positive.
The following figure shows each of these time periods for the U.S. data. Here, real interest rates for 1959-2002 are approximated using the difference between the Fed's constant 10-year yield and the annual U.S. core consumer price index (CPI). As the chart shows, LOIM's measurement behaves very similarly to the Fed's calculations, whose data are only available for a shorter period, Ielpo explains: "So the periods that can be compared with today are 1975Q1, 1980Q2 and 2013Q2. A vertical line marks each of these periods in the graph. The first two periods correspond to the recovery phases following the recessions of 1973-1975 and. 1979-1980. The last one (2013) corresponds to some extent to the overcoming of the debt crisis in Europe, but especially to the first tapering attempt of the Fed. Today, both are the case: we are in a post-recession phase and central banks seem to be reducing the money supply."
Historical trends in real interest rates in the U.S
While readers will likely remember what happened in 2013 (bonds suffered initially, as did equities, but then recovered most of their losses), the first two periods will seem less familiar.
Development of four important assets
The following charts show the performance of four key assets over each of these periods: equities (represented by the S&P500), commodities (with oil prices), the U.S. dollar (dollar index) and gold (XAU). According to the Head of Macro, the conclusion from this analysis is that the normalization of real interest rates does not seem to be a problem for equities (which showed positive performance in both periods over the next 12 months), while the dollar rose.
However, in the face of rising real interest rates, which he believes will likely lead to tighter monetary policy, commodities, both gold and energy, have declined. The latter is not surprising, he says, given the negative correlation between commodities and the dollar. The similarity with the present situation is to be seen particularly in the rise of the stock market. "These points of comparison seem essential at this point to better understand the months ahead", emphasizes Ielpo.
Interest rates could change in the coming quarter, and the wise investor will be prepared for this. Ielpo refers to LOIM's quarterly publication, in which the multi-asset team discusses systematic hedging strategies that can help mitigate their negative impact on a multi-asset portfolio. "However, let's not forget that rising interest rates have a purpose: solid growth, which should support the stock performance. In short, we should be less concerned about rising real yields than about inflation itself: Global portfolios are more likely to benefit from the former than the latter, with medium-term support from equities", says Ielpo.