Putting It All Together: COVID-19 and Policy Decisions Suggest Even Lower for Even Longer
The output for our secular rates model is a range of implied nominal neutral interest rates, which the Active team uses in their fair value framework for rates. Our estimates of the current implied nominal neutral rate range from 1% to 2.25%. Below are the steps that the team takes in arriving at the implied nominal neutral rate:
- Potential GDP (Trend) Growth = Labor Force Growth + Productivity Growth
- Implied Real Neutral Rate = Trend Growth + (R* – G)
- Implied Nominal Neutral Rate = Implied Real Neutral Rate + Estimated Inflation –FAIT/Policy Adjustment
We use this framework to establish estimates of the implied neutral nominal rate in base case, upside and downside scenarios. We then compare these to the current 5-year forward nominal rate, which is indicative of the market’s expectation of the level at which rates stabilize once policy has normalized to neutral levels. The resulting difference is the risk premium, which informs our assessment of longer term value.
Our secular rates framework conveys multifaceted information that can be valuable for investors beyond the actual estimates of long run fair value. Broadly speaking, the model validates the lower-for-longer environment for growth and rates, consistent with the multi-year disinflationary trends we’ve been seeing. Beyond entrenched demographic and productivity trends, we begin to see a picture of a neutral interest rate that is even lower for even longer, influenced downward by the worldwide disruption of a once-in-four-generations pandemic and subsequent policy decisions — including FAIT, QE and a FFR that we believe will be held at zero for longer than is currently priced in the market.
Despite all the disruptions of 2020, we are watchful for any positives resulting from productivity gains, technological transformations in certain sectors such as professional services, and improvements in operating models. We also remain cognizant of how policies like FAIT may influence term premium and breakeven inflation rates over a longer horizon, once the pandemic is in the rear-view mirror.
Investors should consider all of these factors together in setting their capital markets expectations and in particular the implications of Treasury yields that may remain low by historical standards for quite some time to come.
Sources: State Street Global Advisors, Federal Reserve, European Central Bank, Bank of Japan, Bloomberg.