A Look at Prospective Market Returns Amid a New Era of Negative Real Rates

When I look out at what's been going on the last six months, I see financial mania... The Fed, having pumped asset prices to historically high levels, doesn't make me feel comfortable. I feel as anxious today as I've ever felt about the financial world because of my belief that the Fed has been pumping up asset prices in a way that is creating a bit of an illusion. I think the odds are now sort of one in three—very high—that we will look at this as an epic mistake and one of the great financial calamities of all time.

- Peter Fisher, Federal Reserve Bank of New York, 1985–2001

The Third Great Mistake means there is no longer an alternative to higher inflation, and there is also no pain-free way for monetary policy prevent inflation from spiraling higher than intended. It is reminiscent of the circumstances in the late 1960s, and it is fitting that financial markets appear to be in a similar position as well: interest rates are low, risk asset valuations are high, and there is a speculative fervor which has apparently concluded that the entire equity market is now a one decision investment.

- 2021 Annual Letter

One theme we have focused on in these letters over the past three years is what a transition into a regime of negative real interest rates looks and feels like, and the long-term consequences such a regime brings for the markets, and for investors. Since it has been fifty-five years since the last extended period of negative real interest rates began, and forty years since that period of negative interest rates ended, few investors today have any experience navigating such a market environment. For those who do, the memories are distant.

Most investors active in the markets today have only known a market environment defined by positive real rates of return on bonds and stocks, and over the past forty years this environment has been further defined by inflation rates that continuously trended lower. These are trends which supported ever higher valuations for risk assets, and ever longer effective durations for bonds, in a repeat of Warren Buffett’s Bountiful Triple Dip — one of the topics in this year’s annual letter. This regime had been firmly in place since the early 1980s, but it appears increasingly likely we may be witnessing its end. Evidence of the emergence of a new regime has been popping up all around the market landscape over the last year, and it can clearly be seen in the wake of the pivotal June meeting of the Federal Reserve’s rate-setting committee, the FOMC.

In the weeks after Fed Chair Jerome Powell confirmed that the FOMC had begun discussing at its June meeting when it might be appropriate to begin scaling back the pace of its extraordinary balance sheet expansion, yields on long-term Treasury yields continued a slide that had begun in May, when the first rumblings of a policy shift discussion were heard. At the same time Treasury yields fell, the market’s estimates of long-term inflation bucked the trend in yields and remained elevated, with the result being that expected real, inflation-adjusted yields on long-term Treasury securities declined to the lowest rates seen over the past year: the yield on the 10-Year Treasury Inflation-Protected security fell to a new low of -1.19%.

This reaction in the bond market was notable because it was the opposite of the reaction during the Taper Tantrum of 2013, when Treasury yields immediately shot higher when the possibility of tapering the pace of QE was first mentioned. This time, long-term Treasury yields tumbled, with the yield on the 30-Year Treasury bond falling as low as 1.78% in July.

As the entire Treasury yield curve descended below the Federal Reserve’s long-term inflation target of 2% in reaction to the tapering discussion, one conclusion the bond market appeared to reach was that any tapering of asset purchases would result in the Fed Funds rate remaining at zero for a longer period of time. With short-term interest rates at zero, and with the Fed’s $8.2 trillion balance sheet still expanding at a rate of $1.4 trillion a year, this is an extraordinary reaction. A nominal 10-Year Treasury yield trading near 1.2%, below the lowest levels seen in the last decade, suggests there may now be a new working definition of what tightening monetary policy effectively means.