Long-term secular trend in rates – A big issue

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There needs to be a certain fatalism with the current long-term secular trend in real rates. Real rates  are expected to stay low after its continued march down over the last thirty years. This is the reality that has to be grasped by all investors.

An asset allocation decision to hold bonds is not going to provide attractive yields. Alternatively, the big bond bear that has scared investors is unlikely to occur.  Global real rates are expected to stay low, around 1 percent. EM real rates will be higher, albeit lower than in the past. There will be variations based on risk and country specific issues, but the mean levels will stay low by any measure of medium-term horizon.

Long-term real rates have fallen about 450 bps over the last 30 years. Around 400 bps can be explained by the some long-term secular trends. See “Secular Drivers of the Global Real Interest Rate”, Bank of England Staff Working Paper No. 571. A long history shows the 1960-1980’s were unusually high for real rates. The change in headwinds suggests that we will not go back to those old days.

The decline in real rates have been associated with a slowing of global growth, shifts in savings and a decline in the demand for capital. These factors are not going to change in the short-run. The shifts to increased savings are associated with the demographics of aging, higher income inequality, and an increase in precautionary savings by EM countries. The demand for investment has fallen with the falling relative price of capital, lower public investment, and an increase in spreads versus the risk-free rate of return. The combinations of shifts in both supply and demand have resulted in a lower real rate environment that cannot be changed through unconventional monetary policy.

The 1 percent solution is extremely difficult for pension or savers who are looking to hold long-term passive strategic allocations to bonds and receive anywhere near the historical returns on bonds.

The solution has to be more diversification away from bonds, but this diversification has to be toward different investment styles which likely means more active trading. It could be tactical changes to risk premiums or active trading based on exploitation of skill, but buy and hold bond exposure while not generate high returns. Of course, skill trading cannot be used by all investors. Hence, there is a binding constraint on portfolio returns which needs to be faced sooner rather than later.