I was planning to write today about why a 4.5%-5.0% nominal Treasury rate is not only not the end of the world, but actually sort of normal. Naturally, the reason I am even thinking about the topic is because of all of the apparent alarm because the current long bond recent peeked above 5% and the 10-year note at 4.50% continues to flirt with those levels. Because we haven’t seen the 10-year rate above 5% for a sustained period in about 18 years, it is natural that some of the young folks who were raised in an era of free money would think that this is the end of the world.

I’ve previously written about the return of some of the phenomena that we used to take for granted, such as the presence of optionality in the bond contract . After most of two decades of unhealthy interest rates produced unhealthy leverage habits among other unwelcome developments (including the leveraging of the government balance sheet because it was so cheap to borrow for one’s programs with no cost), I suppose it shouldn’t be surprising that there is so much wailing and gnashing of teeth, rending of garments, etc. But for those people who expect the Fed to lower rates significantly, because “after all 2% is the normal level of interest rates,” I am here to say that you probably don’t want the crack-up that would be necessary to make that plausible. The current level of interest rates is inconvenient for many organizations with a borrowing problem, but it is really quite normal.

Anyway, I’d intended to write a longer version of that, and as I started to write something bugged me and I looked back and noticed that I’d already written essentially the same thing a few years ago. At the time (June 2022) I was explaining “ Why Roughly 2.25% is an Equilibrium Real Rate ,” and of course if you add reasonable inflation expectations of 2.5%-3% you get to 4.75%-5.25% as an equilibrium nominal rate (and a bit higher than that for the 30-year, which also incorporates a modest additional risk premium). If you go and read that article directly, you can also get my screed on how models trained on the last 25 years of data leading up to the inflation spike only survived if they forecast a very strong reversion to the mean, and so *eureka* all of those models missed the entire inflation spike. But here is a reprinted snippet (reprinted by permission from myself) outlining the argument for why the current level of long-term real interest rates is about right.

Kashkari made a different error, in an essay posted on the Minneapolis Fed website on May 6 ^th . [1] He claimed that the neutral long-term real interest rate is around 0.25%, which conveniently is where long-term real rates are now.

However, we can demonstrate that logic, reinforced by history, indicates that long-term real rates ought to be in the neighborhood of the economy’s long-term real growth rate potential.

I will use the classic economist’s expedient of a desert-island economy. Consider such an island, which has two coconut-milk producers and for mathematical convenience no inflation, so that real and nominal quantities are the same. These producers are able to expand production and profits by about 2% per year by deploying new machinery to extract the milk from the coconuts. Now, let’s suppose that one of the producers offers to sell his company to the other, and to finance the purchase by lending money at 5%. The proposal will fall on deaf ears, since paying 5% to expand production and profits by 2% makes no sense. At that interest rate, either producer would rather be a banker . Conversely, suppose one producer offers to sell his company to the other and to finance the purchase at a 0% rate of interest – the buyer can pay off the loan over time with no interest charged. Now the buyer will jump at the chance, because he can pay off the loan with the increased production and keep more money in the bargain. The leverage granted him by this loan is very attractive. In this circumstance, the only way the deal is struck is if the lender is not good at math. Clearly, the lender could increase his wealth by 2% per year by producing coconut milk, but is choosing instead to maintain his current level of wealth. Perhaps he likes playing golf more than cracking coconuts.

In this economy, a lender cannot charge more than the natural growth in production since a borrower will not intentionally reduce his real wealth by borrowing to buy an asset that returns less than the loan costs. And a lender will not intentionally reduce his real wealth by lending at a rate lower than he could expand his wealth by producing. Thus, the natural real rate of interest will tend to be in equilibrium at the natural real rate of economic growth. Lower real interest rates will induce leveraging of productive activities; higher real interest rates will result in deleveraging.

This isn’t only true of the coconut economy, although I would strongly caution that this isn’t exactly a trading model and only a natural tendency with a long history. The chart below shows (1) a naïve real 10-year yield created by taking the 10-year nominal Treasury yield and subtracting trailing 1-year inflation, in purple; (2) a real yield series derived from a research paper by Shanken & Kothari, in red; (3) the Enduring Investments real yield series , in green, and (4) 10y TIPS, in black.

The long-term averages for these four series are as follows:

• Naïve real: 2.34 %
• Shanken/Kothari: 3.13%
• Enduring Investments: 2.34 %
• 10y TIPS: 1.39%
• Shanken/Kothari thru 2007; 10y TIPS from 2007-present: 2.50 %

It isn’t just a coincidence that calculating a long-term average of long-term real interest rates, no matter how you do it, ends up being about 2.3%-2.5%. That is also close to the long-term real growth rate of the economy. Using Commerce Department data, the compounded annual US growth rate from 1954-2021 was 2.95%.

It is generally conceded that the economy’s sustainable growth rate has fallen over the last 50 years, although some people place great stock (no pun intended) on the productivity enhancements which power the fantasies of tech sector investors. I believe that something like 2.25%-2.50% is the long-term growth rate that the US economy can sustain, although global demographic trends may be dampening that further. Which in turn implies that something like 2.00%-2.25% is where long-term real interest rates should be, in equilibrium. [2] Kashkari says “We do know that neutral rates have been falling in advanced economies around the world due to factors outside the influence of monetary policy, such as demographics, technology developments and trade.” Except that we don’t know anything of the sort, since there is a strong argument against each of these totems. Abbreviating, those counterarguments are (a) aging demographics is a supply shock which should decrease output and raise prices with the singular counterargument of Japan also happening to be the country with the lowest growth rate in money in the last three decades; (b) productivity has been improving since the Middle Ages, and there is no evidence that it is improving noticeably faster today – and if it did, that would raise the expected real growth rate and the demand for money; and (c) while trade certainly was a following wind for the last quarter century, every indication is that it is going to be the opposite sign for the next decade. It is time to retire these shibboleths. Real interest rates have been kept artificially too low for far too long, inducing excessive financial leverage. They will eventually return to equilibrium…but it will be a long and painful process.

At the time I wrote the passage above, 10-year TIPS yielded about 0.25%; today they yield 2.125%. It turned out that returning to equilibrium wasn’t at all a long process. But it certainly was painful!

Returning to the original point: just because 10-year rates are now approximately at equilibrium is not at all a prediction that they will remain at equilibrium. Indeed, if I made that prediction I would be making a very similar mistake to the one I criticized above. Mean reversion in rates is not a particularly powerful force, when set against an active central bank and a profligate legislature. But if it matters at all, it is very important to correctly identify the mean to which rates should revert.

And it’s not 2%.

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[1] https://www.minneapolisfed.org/article/2022/policy-has-tightened-a-lot-is-it-enough

[2] The reason that real interest rates will be slightly lower than real growth rates is that real interest rates are typically computed using the Consumer Price Index, which is generally slightly higher than the GDP Deflator.