In a bullish address to Congress this week, new Federal Reserve chair Jerome Powell signalled he would seek to raise US interest rates four times in 2018. Following February’s spike in market volatility, this may seem a bold stance. Being upbeat about the US economy, however, is part of the exercise in controlling the narrative around inflation, which Mr Powell expects to hit the Fed’s 2 per cent annual target this year. The line is that strengthening fundamentals are cause for confidence and higher interest rates should be taken as a positive sign that the central bank is not going to allow the economy to overheat.
Although a sharp reaction to US wage growth last month was a reminder that equity prices are sensitive to any news that might undermine the equity premium (the excess return over bonds implied by stocks), evidence suggests that higher real interest rates lead to expectations of higher future returns. This would seem to support Mr Powell’s confidence.
In the Credit Suisse Global Investment Yearbook for 2018, London Business School academics Dimson, Marsh and Staunton found globally that in country years (years for 21 countries for which they have a complete 118-year returns history) with the highest 5 per cent of real interest rates, equities (10.8 per cent) and bonds (9.4 per cent) achieved the highest annualised rates of return of the subsequent five-year period.
The relationship is linear, with the next 15 per cent of highest real rate years seeing the next highest subsequent five-year returns and so on. The academic team do caveat that unexpected rises in the real rate of interest tend to have an immediate lowering effect on prices and returns. The fear of such an unexpected increase was in part behind the February sell-off, which supports this assertion.
The challenge now for Mr Powell and other important policymakers at the world’s central banks, therefore, is to maintain an orderly programme of increases.
