Real Interest rates

Real interest rate

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It's The Real Interest Rate That Counts!

The world short term real interest rate is slightly above 2%.
David R. Kotok at John Mauldin 22/1 2007

There is a tradable inflation-indexed bond (TIPS) issued by a government of high credit quality. Japan, UK and the US are obvious. France is the large issuer of euro-denominated TIPS.

Now that we have a market-based pricing reference for global real interest rates, we can also calculate the global expected inflation rate. To do that we simply take the interest rate on the nominal yield of the corresponding government bond in each currency and subtract the real rate (TIPS) from it.

The difference is the inflation expectation priced into the market.

On any given day the futures contracts and the world's interest rates are arbitraged to within a few basis points.

Eventually the real growth rate and the real interest rate have to converge closer to each other. Free markets will do that over time.

We have argued that the global real interest rate must eventually rise absent a global growth slowdown of monumental proportions.

The problem for bonds is that the current global yield structure has little margin for errors.

Let's sum this up.
Low real interest rates and higher real growth rates mean good things for stocks. They also mean the outlook for bonds is more problematic. Risk can be assessed but must be monitored closely. Central bank credibility is paramount but must not be taken for granted.

At Cumberland, we believe that a real interest rate of 2 ½% is too low to trigger a full recession. In our view it will only bring the growth rate to trend and that is exactly what we have seen to date. At Cumberland, we also believe that a real rate of higher than 3% would be enough to alter this view. If we saw a credible move to a 3% real interest rate, we would begin to buy TIPS and to lighten our allocation to stocks.

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