Long-term real interest rates and the global economic crisis

adminonDecember 22, 2022February 19, 2023Leave a Comment

The year 2022 will be remembered as the year of the great reset. The reversal of monetary policy from an unconventional, steady state of QE to a classic, conventional state has surprised most market participants. In hindsight, even central bank governors could not have imagined that markets would grant them an exit that has so far occurred without major systemic collateral damage. The change is most evident in the level of long-term 30-year U.S. real interest rates. This long-term real discount rate rose from -0.50% at the beginning of the year to +1.84% at present. A remarkable adjustment that catapults us close to an average level of 2.00% in 30-year real interest rates observed in 2000-2008. In fact, central banks have decisively increased their room for maneuver. You can go back to the interest rate policy toolkit to manage cyclical or countercyclical outcomes. What a result!

Since the pace of the adjustment has been so brutal, it will take a while for monetary policy to filter through. It works with a lag and trickles down to the level at which investment decisions are made, whether households or firms. This last sentence deserves to pause. It is important to realize that such a sudden shift could have changed the potential economic growth downward, as it changes the plans of households and private companies under financial constraints.

At the household level, there is the dream of buying a house. The home affordability index for first-time buyers fell to 68 toward the end of the second quarter of 2022. This series began in 1986. The last time such a value was reached was in the summer of 2006. Between 1986 and 2006, the index averaged 80. I want to include the Bloomberg description of this index because it embodies the U.S. middle class: "This affordability index shows the ability of renters who are potential first-time buyers to qualify for a mortgage for a first home. If this index is 100, the typical first-time buyer can afford a typical first home with a 10% down payment under the given financial conditions. Median income represents the typical income of a renter family with wage earners between 25 and 44 years old.

The rise in long-term nominal and real interest rates has pushed the 30-year fixed mortgage rate toward 7.25%, near the highest levels reached in 1999-2000. October's Homebuilder Sentiment Index fell to 38, approaching the March 2020 pandemic outbreak low of 30 and a far cry from the 90 at the end of 2020, when central banks pushed long-term interest rates to historic lows. Housing demand is faltering rapidly. The monthly supply of new homes entering the market has risen to over 10.4 months, a level not seen since – yes, again – 2008. The bigger picture becomes clear when you consider that the health of the housing market and economic growth conditions are positively correlated. Even if the U.S. real GDP growth numbers for the third quarter are correct, we can expect challenging results in the coming quarters. The financial conditions for the budgets have tightened drastically. Punktum. Similar conditions prevail in the United Kingdom, exacerbated by the conflict between a central bank pursuing orthodox policies and the Chancellor of the Exchequer wanting to pursue unorthodox fiscal policies. A combination that the markets abhor. It almost brought the gilt market to a standstill. On the European continent, housing affordability has not deteriorated to the level of the US or the UK, but the trend is clear.

If we take a quick look at the private sector, it is also clear that a cautious and hesitant management has been established. Geopolitical uncertainty, wage inflation and overall higher manufacturing costs are presenting corporate executives with difficult budget negotiations for the next year. Operating revenues will be squeezed in various recession scenarios while operating costs increase, and on top of that, qualified personnel will become a precious commodity. The CEO Confidence Index, which measures the degree of optimism or pessimism for the U.S. economy over a one-year horizon, is at 5.92. It has recovered from a mid-year low of 5.12. Interestingly, it is holding at the level of summer 2006. It is a so-called coincidence indicator that changes simultaneously with economic conditions.

So, CEOs still tend to be optimistic, even though inflation has wreaked havoc in 2022, but a credit crunch may not be around the corner and is not a base case scenario… yet.

At this point, it is important to take a look at the past and in particular at the great financial crisis of 2008. In early 2008, 30-year real interest rates hovered around 1.70%, breaking through the 2.00% resistance level in the spring. However, by the end of October 2008, the 30-year real interest rate had jumped to 3.25! The damage that resulted was enormous. Global markets were buffeted by a credit crunch, which market participants countered only by assuming that large-scale central bank asset purchases (QE) initiated in late 2008 would be able to calm the system and get credit markets back on track.

The FED is well aware that a further increase in real interest rates from current levels could lead to undesirable outcomes. The market assumes a final key interest rate of 4.75% – 5.00. A level that is expected to be reached in spring 2023. The US real interest rate for 30-year bonds of 1.84% also fully reflects this information.

The key message today is that any increase in expectations for U.S. federal funds rates beyond 5.00% could trigger a nonlinear increase in the likelihood of a credit crunch, as actually occurred in the second half of 2008. Credit spreads could soar. Shares could experience another painful downturn. At this point, the Fed has not made a policy mistake. But it is on the edge of the abyss. To continue, the baseline scenario should see a FED top rate (well) below 5%. Such a scenario, with the Fed signaling prudence, would stabilize equity markets and possibly boost bond markets. The risk scenario in which policy rate expectations rise above the 5.00% threshold could quickly turn into a black swan.

DPAM (Degroof Petercam Asset Management) is a leading asset management firm with assets under management of €50.7 billion as of December 2021. We manage investment funds and discretionary mandates on behalf of institutional clients and various distribution partners. We are committed to providing our customers with solutions based on truly active management.
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The interest rate you are offered by a lender has a big impact on the cost of borrowing money.

A lower interest rate makes taking out a loan or using a credit card less expensive because less interest is added to your monthly payment. Lower interest rates are highly desirable because you pay less money to the person who lent you money.

Interest rates for credit cards and loans are not set arbitrarily. Banks use your credit score to determine your interest rate.

Credit score vs. Interest rate

Your credit score is a number that measures your creditworthiness. It tells lenders how likely you are to pay your bills on time or repay borrowed money.

Higher credit scores are best because they show that you have handled credit well in the past and are likely to pay new loans on time. Lower credit scores show that you have made some big mistakes in the past and may not make all your payments when you get new credit.

You can have several different credit scores depending on who is doing the calculations, but your FICO score is the one most commonly used. These credit scores range from 300 to 850, with a score above 670 considered good and a score above 740 considered very good.

The interest rate you are charged for a loan is how banks make money and limit risk. If a bank feels you are more likely to default on a loan, it may want to charge you a higher interest rate so it can recoup more of the cost of the loan early on.

The better your credit score, the greater the risk you pose to a bank or other financial institution. This means the higher your credit score, the lower your interest rate.

How credit scores affect credit card interest rates

Credit card issuers provide a range of possible interest rates with each credit card offer.

For example, a card may advertise an APR of 13.99% to 22.99%, depending on your credit score. Your final APR would be somewhere in this range, depending on your credit score and other risk factors.

Card issuers won't specify what credit score will get you a certain interest rate. This isn't determined until you submit your credit card application. Generally, if you have a good credit score, you can expect a lower APR. If you have a poor credit score, you will receive a higher APR.

How credit scores affect loan interest rates

For loans, an average interest rate is often quoted instead of a range. If you have a good credit score, you may qualify for an interest rate that is at or below average. However, if you have a poor credit score, your interest rate can be much higher than average.

A higher credit score does not guarantee you the lowest interest rate. Mortgage lenders also consider other factors when setting the terms of your loan, such as.B. Yours:

Credit report
Debt amount
Income
Assets and savings

You can use a credit savings calculator to find out how much you can save on a loan based on your credit score. The calculator shows sample APRs and monthly payments for mortgage or auto loans with specific terms for different credit ranges.

You won't know what APR you'll be offered until you apply for and are approved for a loan. Different lenders may also offer you different interest rates. When you take out a loan, it may be worthwhile to get interest rates from several lenders, regardless of how high your credit score is.

How you can improve your interest rate

Banks are required to give you a free copy of your credit score if it results in you being approved for a less favorable interest rate. The credit score disclosure also includes some details about what affects your credit score.

For a FICO score, these factors include:

Payment history: How often you made payments on time (or not) accounts for 35% of your credit score.
Debt amount: How much outstanding debt you already have accounts for 30% of your credit score.
Length of credit history: How long you've been borrowing and repaying money accounts for 15% of your credit score.
Credit mix: The variety of credit accounts you have accounts for 10% of your credit score.
New credits: how recently you have opened new credit accounts and how many you have opened accounts for the last 10% of your credit score.

To improve your chances of getting a better interest rate, you can spend a few months improving your credit score. This is especially important with a larger loan like a mortgage, where a higher credit score can reduce your monthly payment by hundreds of dollars. This can save you tens of thousands of dollars in interest over the life of the loan.

Also, in previous inflationary periods, service price inflation was often very persistent," writes Neuberger Berman's Brad Tank. (Image pd)

Because of stubborn services inflation and only a weak downturn, central banks are likely to maintain high policy rates for longer, writes Brad Tank, chief investment officer – fixed income at Neuberger Berman.

Prices often fluctuated particularly wildly in 2022 on days when the U.S. consumer price index was released. Year-over-year headline and core inflation were recently in line with consensus expectations. "We have had another reassuring month of steady declines. However, the structure of inflation differed somewhat from expectations. That may not have been so pleasant," says CIO Weekly.

Moderate

When the November numbers came out a month ago, investors reacted with delight. Inflation appeared to be easing across the board. "Inflation fell again in December, and food, energy and goods actually became cheaper in most cases. Service inflation, on the other hand, continued to rise. Even in previous inflationary periods, the rise in service prices was often very persistent," writes Tank at Neuberger Berman. The immediate market reaction was then as mixed as the data, they said. "Financial conditions tightened quickly, but then a sustained easing ensued. Stocks rose, yields fell, the U.S. dollar weakened, and the price of gold rose. After a few hours, investors had dismissed this as just another relatively innocuous set of numbers."

Central bank signals

The situation was made more confusing by comments from Patrick Harker, president of the Philadelphia Fed. On the one hand, it is prepared to make smaller rate hikes of only 25 basis points, but on the other hand, it wants to keep raising rates until inflation returns to its target level. Earlier in the week, central bank governors from Boston and Atlanta had already made similar comments.

"Back in November, we had noted that investors were increasingly paying more attention to economic data than to the Fed's strident rhetoric," Tank writes. Last week, the World Bank nearly halved its 2023 growth forecast, to just over 1.7%. For the developed world, it now expects growth of just 0.5% instead of 2.2%. Manufacturing purchasing managers' indexes signal shrinking industrial production in the U.S., Europe and Japan. The U.S. services PMI also just fell below 50, from 56.5 to 49.6, which also points to a recession, he said.

"Why then should we be concerned about service prices?", asks the Chief Investment Officer – Fixed Income at Neuberger Berman. "Since a sharp downturn cannot be ruled out, many investors are wondering whether central banks will have to cut interest rates again in the second half of 2023. The development of the bond markets also fits in with this," he adds.

Stubborn inflation

"On the other hand, we take the Fed and the other central banks at their word. We still believe inflation will remain stubbornly high. However, we also believe that goods inflation has passed its peak."Energy and commodity prices are not easy to forecast because they depend on many factors – the economic fallout from the war in Ukraine, the reboot of the Chinese economy and the weather," he said. In the services sector, Neuberger Berman expects housing costs to gradually decline despite the December increase, he said.

Otherwise, however, service inflation is likely to remain high because wages are rising and staffing shortages still prevail. Most recently, U.S. jobless claims fell to a three-month low, below expectations. At 3.5%, the U.S. unemployment rate is near a 50-year low, and the euro area unemployment rate is also at a record low of 6.5%.

Increasingly, there is a case for much higher wage settlements in Japan, Europe and the U.S. As recently as January, striking New York nurses won wage increases of no less than 19%. "Workers want to participate more in economic growth. We think this is a long-term and global development. We can well imagine that service inflation will remain stubbornly high in 2023 and that the economy will slow only slightly. Central banks could then hold on to high interest rates for even longer", concludes.

Asset managers expect inflation in the U.S. and euro area to fall to between 3.0% and 3.5% by the end of 2023. This would be much lower than recently, but still above the target value. "The maximum in key and short-term interest rates would then be permanent. We are more optimistic about interest rate volatility, which could be much lower than last year. For the first time in a long time, we think yields are reasonable again in view of the duration risk. We think they provide a sufficient buffer again. The last few years have shown us that the economy and the world situation can always surprise us. Nevertheless, we believe 2023 holds more opportunities and significantly less risks for bond investors than 2022.

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