“Anyone can hold the helm when the sea is calm.” – Publilius Syrus
Three weeks ago, many equity markets were at all-time highs. As of this morning, the S&P 500 is down 25% year to date in what feels like the fastest decline in the history of declines. Financial markets are experiencing the highest sustained volatility since the Great Depression ninety years ago. Observers are getting used to seeing 10% daily swings in many equity markets, and sometimes many times that in individual securities. While coronavirus is all over the financial news, it’s not what I want to talk about today. Today I want to talk about the recent explosion in real interest rates, which is – to me – the most timely indicator of the forces driving this volatility. Until real interest rates calm down, I don’t expect volatility to moderate, as I explain below.
INTEREST RATES: GETTING REAL
Nominal bond yields are the sum of three separate components. The first is default risk, the risk that a bond won’t be repaid, which you can monitor in the credit default swap market (CDS) and is near zero for the U.S. Treasury market. The second is the market’s expectation for future inflation, which we can track in the “TIPS” market. Tips are bonds that pay a coupon that changes to keep the investor whole on an inflation adjusted basis. The third is real interest rates, which I calculate as nominal interest rates minus inflation expectations mentioned above and that I display in the chart below in which the black line shows the trend in interest rates for U.S. government thirty-year Treasury bonds. You can see that rates have been declining for some time, more than the decline in inflation expectations (shown in blue), which has driven real interest rates (red) lower. I have long believed that falling real rates are necessary to keep our debt-laden economy functioning. That hypothesis is finding a lot of support in recent days as real rates spike and markets crash. I don’t think this is a coincidence. The same thing happened before in 2008, as you can see from the two circled areas on the chart. Both spikes were driven by a collapse in inflation expectations, which in my opinion is the single biggest threat to financial markets. I expect volatility to continue in our overindebted world until these real rates decline.