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Thursday, January 27, 2022 / 05:28 PM / by Nassira Abbas and Tobias Adrian, IMFBlog / Header Image Credit: Getty Images
A large and
sudden jump in real interest rates could lead to a further selloff in stocks.
Supply disruptions coupled with strong demand for goods, rising wages
and higher commodities prices continue to challenge economies worldwide,
pushing inflation above central bank targets.
To contain price pressures, many economies have started tightening
monetary policy, leading to a sharp increase in nominal interest rates, with
long-term bond yields, often an indicator of investor sentiment, recovering to
pre-pandemic levels in some regions such as the United States.
Investors often look beyond nominal rates and base their
decisions on real rates that is, inflation-adjusted rates which
help them determine the yield on assets. Low real interest rates induce investors to take more risks.
Despite somewhat tighter monetary conditions and the recent upward move,
longer-term real rates remain deeply negative in many regions, supporting
elevated prices for riskier assets. Further tightening may still be required to
tame inflation, but this puts asset prices at risk. More and more investors
could decide to sell risky assets as those would become less attractive.
Differing outlooks
While shorter-term market rates have climbed since central banks' hawkish turn in advanced economies and some emerging markets, there is still a
sharp difference between policymakers' expectations of
how high their benchmark rates will rise and where investors expect
the tightening will end.
This is most obvious in the United States, where Federal Reserve
officials project that their main interest rate will reach 2.5
percent. That's more than half a point higher than what 10-year
Treasury yields indicate.
This divergence between markets and policymakers' views on the most
likely path for borrowing costs is significant because it means investors may
adjust their expectations of Fed tightening upward both further and faster.
In addition, central banks might tighten more than they currently
anticipate because of persistent inflation. For the Fed, this means the main
interest rate at the end of the tightening cycle might exceed 2.5 percent.
Implications of the rate-path
divide
The path of policy rates has important implications for financial markets and the economy. As a result of high inflation, real rates are historically low, despite the recent rebound in nominal interest rates, and are expected to remain so. In the United States, long-term rates are hovering around zero while short-term yields are deeply negative. In Germany and the United Kingdom, real rates remain extremely negative at all maturities.
Such very low real interest rates reflect pessimism about economic
growth in coming years, the global savings glut due to aging societies, and
demand for safe assets amid higher uncertainty exacerbated by the pandemic and
recent geopolitical concerns.
The unprecedented low real interest rates continue to boost riskier
assets, notwithstanding the recent upward move. Low long-term real rates are
associated with historically elevated price-to-earnings ratios in equity
markets, as they are used to discount expected future earnings growth and cash
flows. All things being equal, monetary policy tightening should trigger a real
interest rate adjustment and lead to higher discount rate, resulting in lower
stock prices.
Despite the recent tightening in financial conditions and concerns about the virus and inflation, global asset valuations remain stretched. In credit markets, spreads are also still below pre-pandemic levels despite some modest widening recently.
After an exceptional year supported by solid earnings, the US equity
market started 2022 with a steep retreat amid high inflation, uncertainty about
growth and weaker earnings prospects. As a result, we expect that a sudden and
substantial rise in real rates could cause a significant drop for US stocks,
particularly in highly valued sectors such as technology.
Already this year, the 10-year real yield has increased by nearly half a
percentage point. Stock volatility soared on greater investor nervousness, with
the S&P 500 down more than 9 percent for the year and the Nasdaq Composite
measure tumbling 14 percent.
Impact on economic growth
Our growth-at-risk estimates, which link future economic growth downside
risks to macrofinancial conditions, could increase substantially if real rates
rise suddenly and broader financial conditions tighten. Easy conditions helped
global governments, consumers, and businesses withstand the pandemic, but this
could reverse as monetary policy tightens to curb inflation, moderating
economic expansions.
In addition, capital flows to emerging markets could be at risk.
Stock and bond investments in those economies are generally seen as being less
safe, and tightening global financial conditions may cause capital outflows,
especially for countries with weaker fundamentals.
Looking ahead, with persistent inflation, central banks face a balancing act. All the while, real interest rates remain very low in many countries. Monetary policy tightening must be accompanied by some tightening of financial conditions. But there could be unintended consequences if global financial conditions tighten substantially. A higher and sudden increase in real interest rates could lead potentially to a disruptive price revaluation and an even larger selloff in stocks. As financial vulnerabilities remain elevated in several sectors, monetary authorities should provide clear guidance about the future stance of policy to avoid unnecessary volatility and safeguard financial stability.
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