Real Rates Are the Real Problem – DBk

US 10 year yield is around 2.5% which is quite low. But if you take inflation into account, the situation is far worse. But real rates should be higher, based on the current fundamentals of the economy. This means that central banks should have ended QE some time ago already, but they can’t because they are prisoners of financial markets. They are just stuck in a mess they helped creating in the first place, because they never got the guts to stop banks around the world, and especially in the US, from doing stupid things.

Deutsche Bank’s Binky Chadha, Parag Thatte and Rajat Dua have an interesting reading of this:

« Real rates are far below (-2pp) levels implied by prevailing GDP growth rates, which have historically provided an anchor. Monetary policy has been the key driver of this divergence. If monetary policy had been set in keeping with its historical reaction function, prevailing growth and inflation would have policy rates at 3.5% today.

Monetary policy has been set instead on a view of the future that embodies a break from the past: in the inflation-unemployment relationship; and in a long run slow down in productivity growth.

But the inflation-unemployment relationship does not look to have changed. The Fed seems to be missing a key driver, the dollar, including which indicates no change in the responsiveness of inflation to unemployment. Nor does productivity growth look to have fallen below its historical trend in this cycle. Indeed we see the historical drivers of productivity aligning for an inflection up. »

The only way to get out of such a messy situation is that markets expectations for rates move higher, i.e. that they start pricing in the normalization of monetary policies and the end of QE.

But so far, financial markets have been acting as junkies and they are not ready to get clean.

Higher rates are probably the best thing that will happen at some point, even if this entails higher volatility for financial markets. They had a good time since 2009. Now it’s time the real economy takes over and that financial leverage comes to an end.