Thread by @avasthiniranjan

A 🧵 on how negative real rates impact economy, savings and markets.

What should investors do during periods of negative real interest rates like now?

1/n

Real interest rate is
(Nominal interest rate - inflation)

If RBI policy rate is 4% and inflation is 2%, then the real interest rate in the economy is 2%

On the other hand, if inflation is 6%, then the real interest rate is -2% (negative real rate)

2/n

Today, we are in a negative real rate territory.

RBI policy rate is 4% (actually lesser than this due to excessive liquidity) and inflation is inching between 5% to 6%. Hence, the real rate in the economy is negative in the range of 1% to 2% since months now.

3/n

How do negative real rates impact savers, stock markets and the economy as a whole?

Savers: Traditional savers are definitely big losers when real rates are negative. Imagine earning 4% in savings account when inflation is 6%. You are losing 2% value of your investment.

4/n

Hence, savers are encouraged to take more risks with their investments in their hunt to earn postive real returns.

This could potentially explain the rush into equities or other risky assets during such periods. Even today.

5/n

Economy: Central Bankers deliberately keep real rates negative to accomodate spending behaviour and push economy revival.

Since money in bank can lose its value due to negative real rate, people prefer spending it upfront and front load their future purchases.

6/n

Borrowers find it rewarding to borrow money at negative real rate and spend on purchases and buying real assets.

Businesses also find it rewarding to borrow are negative real rate and invest in their future growth.

Negative real rates broadly helps economy revival.

7/n

Markets: Equity markets boom as investors shift their investments from negative yielding assets to more riskier assets.

Negative real rates promote riskier behaviour amongst investors. If real rates remain negative for long it may create asset price bubbles.

8/n

Bond markets react to negative real rates in a strange way. Short term rates are usually very low due to higher liquidity, but long term rates remain higher due to higher inflation expectations.

Yield curve is steep with high difference between short and long term rates.

9/n

How should investors approach such periods and where they should invest?

Since negative real rate promotes risk, investors should be cautious before investing in any asset class. They should see how much risk they are building in their portfolio during such period.

10/n

With uninterrupted rise, making returns in equities seems much easier.

5% in a FD over a year vs 5% returns in a month or even faster can alter behaviour of any person.

Investors stepping into equities for 1st time should consider hybrid funds instead of pure equity funds

11/n

They should target earning postive real returns and not higher returns. Funds like Equity Savings Fund and Balanced Advantage Funds are good choice for such 1st timers.

These funds can potentially earn positive real returns and also protect from equity market volatility.

12/n

Fixed income investing becomes very tricky during such period as yield curve is steep.

Short term rates are lower and hence, low duration funds can earn negative real returns.

Long term rates are higher and attractive, but investing in long duration funds can be tricky.

13/n

Once interest rates start rising, long duration funds may hurt due to fall in bond prices.

A potential solution during such period that can help capture higher yields with lower duration risk is investing in roll down funds or target maturity funds.

14/n

These funds can help capture higher yields and as their maturity rolls down, their yields fall due to steep yield curve which can potentially generate capital appreciation plus accrual returns.

If you stay invested till maturity they can also protect from rising rates.
15/n

Investors can also spread their investments across yield curve at points that are giving positive real returns.

For eg: 1 yr yields are 4% giving negative real return, but yields beyond 7 yrs maturity are offering 6% plus yield and positive real return.

16/n

The moot point is, when real rates are negative, investors should be extra cautious while taking exposure to newer asset class.

They may look appealing as risk premia reduces in risky assets but their they may alter your risk profile.

16/n

Negative real rates have become a tool for central bankers in the west to revive economy without other monetary or fiscal measures.

Back home RBI may keep real rates negative for longer period given constraints on big fiscal spend by centre.

Be aware and invest wisely.

17/end