Searching for USA's "R star"

3 December 2018

Unobservable neutral real rate of interest

By over tightening, or not correctly estimating R-star, central banks are often the cause of recessions.

R-star is the biggest issue for financial markets right now, more important than trade wars and diverging major economy growth.

R-star is the theoretical and unobservable neutral real rate of interest - effectively the tipping point between expansionary and contractionary economic cycles.

Debate shifting to upper bound of rate cycle

Following 10 years of extreme monetary policy characterised by quantitative easing and negative real interest rates, the main debate was how to deal with the zero lower bound for US interest rates in a low growth world.

Since the end of 2016, strong growth and low unemployment in the US has returned debate to how high the US Federal Reserve (Fed) Funds rate will rise before the economic cycle slows down.

At what real interest rate level does growth begin to slow?
At what real interest rate level does growth begin to slow?

Past performance is not a guide to future returns.
Source: Martin Currie Australia, Factset; as of 30 October 2018. Red bands = decelerating or below-trend growth

Impact on market is tanglible

The inflection point, from growth to slow down, is critical to major economy growth and financial markets. It will impact bond yields, credit spreads, the Australian dollar and other currencies, global and domestic equities, and equity style factors.

The Fed’s move from a negative real rate to a neutral real rate in 2018 has so far already caused ructions in emerging market currencies and equities, and is arguably the main reason behind October’s global equity market sell-off and the volatility of the US equity market.

The fed is on course to find its r-star

By over tightening, or not correctly estimating R-star, central banks are often the cause of recessions.

With US CPI running at around 2%, the Fed expected to raise rates by 0.25% four times over the next year.

The last two economic slowdowns occurred after real rates rose above the 2% level, but most economists believe that R-star in the current market could be well-below its historical theoretical level, and may be sitting at closer to 1%.

The Fed Funds rate could easily be closer to 3.25% and real rate above 1% by the end of 2019.

Should current market turmoil mean a departure from history?

There are a few variables that views of a “new normal” lower R-star could be tested: For example, we ponder:

  • does R-star continue to rise above historical levels because of digital productivity and disenfranchised labour returning to the workforce?;
  • does the trade war and diverging economic growth cause the Fed to instead pause its expected rate rises?; or
  • is R-star actually much lower, as suggested by already slowing auto sales and new housing permits, and we are already very close to the tipping point?

What happens next?

Equity markets are known for predicting two recessions for every one that occurs. Some sell-offs will be good buying opportunities.

We don’t know what R-star will be, and when we will reach it, but determining the likely path and the degree to which this is priced across different markets will be key to performance of equity strategies, both in Australia and globally over the next two years.

It is why we are currently holding significantly more dry powder in our portfolios than we have for the last 10 years.

Important information

Past performance is not a guide to future returns.
The information contained in this presentation has been compiled with considerable care to ensure its accuracy. But no representation or warranty, express or implied, is made to its accuracy or completeness. Market and currency movements may cause the capital value of shares, and the income from them, to fall as well as rise and you may get back less than you invested.

Martin Currie has procured any research or analysis contained in this presentation for its own use. It is provided to you only incidentally, and any opinions expressed are subject to change without notice. The opinions contained in this document are those of the named manager(s). They may not necessarily represent the views of other Martin Currie managers, strategies or funds. Please note the information within this report has been produced internally using unaudited data and has not been independently verified. Whilst every effort has been made to ensure its accuracy, no guarantee can be given.