The idea of a new normal in the aftermath of the Global Financial Crisis 15 years ago was a common theme amongst market participants. The Great Moderation of the mid-1980s to 2007 was highlighted by long and sustained economic expansions with stable inflation that could hardly have done less to prepare investors for what was to follow.
Deleveraging by U.S. consumers following the housing bubble paired with an anemic government fiscal policy response meant that monetary policy was left to do the bulk of the heavy lifting as subpar economic growth gave way to a stretch where too-low, rather than too-high, inflation was the primary problem facing central banks. The net result was the first 0% policy rate from the Federal Reserve and other global central banks, not to mention negative policy rates later employed by others, on top of new and alternative policy tools such as large-scale asset purchase programs.
Now it seems as though those issues have reversed. The U.S. fiscal response to the pandemic went above and beyond, economic growth has been persistently above long-term trend levels, and inflation is—of course—well above target levels. As a result, the Fed has hiked rates to levels not seen in over 20 years, with similar outcomes for most major global central banks.
After a decade of investors navigating through zero and even negative-interest-rate policy regimes, what might the next five, 10, and 15 years look like for central bank policy, and more importantly, have we actually left the era of low interest rates behind?
The stars are the landmarks of the universe
“As is often the case, we are navigating by the stars under cloudy skies.” That was Fed Chair Jerome Powell in an August speech referring to the stars that guide the Fed, and the uncertainty under which it is operating. In Fed parlance, the “stars” policymakers are navigating by are the natural rates of interest, or r* (pronounced r-star) and the natural rate of unemployment, or u*.
And while perhaps rather poetic for a Fed chair, the theme of celestial navigation is one he has discussed at numerous points during his tenure and could give us an idea of what it means for the near-term policy outlook and perhaps what lies beyond.
To be clear, these theoretical natural rates of interest and unemployment—or the levels that should prevail at times of price stability and full employment—are just that: theoretical. But there are numerous models that attempt to estimate these celestial beings.
The first chart shows one of the most common models co-created by current New York Fed President John Williams to estimate the prevailing real natural interest rate, which is adjusted for inflation. This natural level still sits at just 0.56% on a real basis, or 2.56% when adding the Fed’s 2% inflation target.
One estimate of the “natural” interest rate suggests we’re still in the era of low rates
The line chart shows a model estimate of the so-called “natural” interest rate quarterly from December 1973 through June 2023, and the rolling 10-year average since 1983. The natural interest rate declined sharply after the global financial crisis in 2008; the 10-year rolling average fell from roughly 3% in 2008 to less than 1% in 2019. The natural rate currently remains far below its level before the financial crisis, with the model estimate around 0.5%.
Note: Model based on the Holston-Laubach-Williams estimate of the real (inflation-adjusted) natural rate of interest.
Source - RBC Wealth Management, Bloomberg
Why might this be? Interest rates have been in a state of steady decline since the Great Inflation of the 1970s and 1980s, while other research has suggested interest rate levels have been in a steady state of decline over the past 700 years. The key drivers of this so-called natural rate of interest are rather simple, in our opinion. Global potential growth has naturally slowed over time as economies have matured. The biggest driver, demographics, remains firmly in favor of lower natural rates as the global population ages, continuing to fuel excess savings and demand for what are perceived to be safe assets. Risk aversion, particularly after the economic and psychological harm of the financial crisis, is also perhaps another factor anchoring natural interest rates lower.
But whether it’s a 40- or 700-year trend, those are powerful forces to contend with, suggesting that this current episode of historically high policy rates in the U.S. and globally is perhaps more likely an aberration rather than a break from the post-financial crisis era. In fact, Williams has maintained at numerous points this year that he sees little reason to think the natural rate of interest has moved higher.
That said, there may be some reasons to think that natural interest rates could indeed begin to trend higher in the years ahead.
The Fed’s North Star
There’s one more star the Fed navigates by, but this one is easy to observe and has remained constant for some time: the natural rate of inflation, or π*, which has been formally 2% since 2012.
As the below chart shows, Fed policymakers also broadly agree with the view that the longer-run natural interest rate is around 2.50%, a real level of 0.50% plus the 2% inflation target, though at the margins this has begun to shift higher with some at the Fed seeing it around 3.3% following the Sept. 19–20 policy meeting.
As markets price a higher natural rate, will the Fed projection follow?
The line chart shows the market-based expectation of the longer-run U.S. policy interest rate monthly from January 2007 through September 2023, and the Fed’s quarterly median projection of the longer-run rate from January 2012 through June 2023. Two U.S. economic recessions are highlighted: December 2007 through June 2009, and February 2020 through April 2020. The Fed’s estimate steadily declined from 2012 to 2019, and has remained largely unchanged since 2019 at 2.5%. Although the Fed’s estimate has remained stable, the market-implied rate has risen from roughly 1.5% in mid-2020 to roughly 4% today.
Note: Market-based expectations based on 5-year, 5-years-forward Overnight Index Swap rate; Fed projection based on Federal Open Market Committee target.
Source - RBC Wealth Management, Bloomberg
The market may also be entertaining the idea that natural rates could shift higher as gauged by an index that captures what the market expects overnight rates to average over five years, beginning five years from now. It too has consistently trended lower since 2007 only to reverse to nearly 4% recently.
In our view, there are perhaps two key reasons why, and maybe one ancillary one. The first likely stems from the strong policy response to the pandemic that sparked a brisk recovery and an environment where inflation is modestly more structural than it has been in some time.
The second relates to the Fed’s North Star—the 2% inflation target. Powell has also highlighted in recent years the challenge posed by low natural rates, which is essentially that during economic downturns or times of stress the Fed only has a small window between 2.5% and 0.0% within which to cut rates in order to provide economic stimulus. After the effective lower bound of 0.0% is reached, the Fed has to revert to other alternative tools beyond the policy rate.
If real natural rates are indeed likely to remain historically low and near 0.0%, then the only way to create a larger window to manage policy rates is to raise the inflation target. This has been a regular point of discussion in recent years, and though the Fed would never broach the topic at a time when inflation remains entirely too high, we see a decent chance the Fed could begin to publicly explore the idea as early as 2025.
Lastly, there’s the issue of artificial intelligence (AI), though admittedly it is a relative unknown as it relates to natural rates, that could be an underlying longer-term dynamic that has investors reassessing the future interest rate levels. But low productivity has long been a drag on potential economic growth rates. Should AI deliver on its rosiest of promises, then perhaps markets may be starting to price in the chance that AI fuels a productivity boom and, therefore, higher potential growth, though this is surely a longer-term issue.
The normal verdict
What does all of this mean for investors? Our base case is that the long-term trend of lower rates will remain largely in place. On the issue of a new normal, or a reversion to some old normal, we maintain a view that there really is no normal. Monetary policy and central bank toolkits will continue to evolve with each business cycle and perceived economic era.
Within that framework then, it’s likely the case that the current yield environment presents a smorgasbord of opportunities for investors. As the final chart shows, cash has had its day in the sun since the Fed began raising rates in March 2022 delivering total returns of nearly 5% based on 1–3 month Treasury bills, while longer-dated treasuries are still down by over 20%, one of the biggest performance gaps on record. But the tide may already be shifting, as longer-dated bonds are already clawing back returns with central banks appearing to be at or near peak rate levels.
The outperformance of cash may have run its course
Rolling 15-month total returns
The line chart compares the rolling 15-month total returns for the Bloomberg US Treasury Bills 1-3 Month Index, Bloomberg US Intermediate Treasury (1-10 Year) Index, and Bloomberg US 10+ Year Treasury Bond Index monthly from June 1993 through September 21, 2023. Cash and short Treasury Bills have returned 4.8% since the Fed began raising rates in March 2022, while intermediate Treasury notes are down 2.6% and long Treasury bonds are down 26.7%. However, the chart shows that intermediate and long Treasuries have outperformed cash more often than not over the past 30 years.
Note: Cash represented by Bloomberg US Treasury Bills 1-3 Month Index, intermediate Treasuries by Bloomberg US Intermediate Treasury (1–10 year) Index, long Treasuries by Bloomberg US 10+ Year Treasury Bond Index.
Source - RBC Wealth Management, Bloomberg
But attempting to time the market is only likely to mean that an investor will miss it altogether. So, we would simply employ a strategy in coming months and quarters of gradually moving out of cash and short-dated bonds in a higher for longer, but maybe not forever, rate environment.