Thread by @MacroAlf

Plenty of people are calling for an imminent stock market crash, but they are missing a key point: inflation-adjusted interest rates are still way below the estimated equilibrium levels!

Why does that matter?

1/11

Real yields are very relevant for savers, investors, borrowers and asset class valuations: it's not only the absolute level that matters though, but also the relative level against the equilibrium real interest rate (r*).

A low absolute risk-free real interest rate matters as:

1) It punishes savers and investors by rewarding very little (or even inflicting negative returns) on savings and risk-free investments

2) It helps borrowers to reduce their real debt servicing cost, as debts are inflated away while nominal interest rate costs remain low. With the same real income, borrowers are now able to ''afford'' more debt as servicing costs are lower

3) As long as earnings and nominal economic activity deliver, very low risk-free real interest rates will help drive portfolio inflows into risk assets and encourage higher valuations.

But it's not all about the absolute level: real yields relative to the equilibrium level r* are also very important
R* is the equilibrium real interest rate the economy can withstand while generating its potential, long-term growth and without overheating or cooling down too much

R* is influenced by long-term drivers of real economic growth, and in particular by the growth of the active workforce (labor supply growth), its productivity and capital productivity.

The equilibrium rate r* has obviously been trending down fast over the last 40 years as our active workforce keeps growing less and less (ageing population), disruptive technologies advance at a very fast pace and capital misallocation is all over the place.

Hence, lower real yields are a trend likely to stay but what matters is ''how low'' they are against estimates of r* -> my own model points to r* being negative (!) in EU.

Nevertheless, observed real yields are now very low not only in absolute terms, but also against r*.

In 2013 (taper tantrum) and 2018 (equity market sell-off), real rates significantly overshoot r* for a while causing distress in the system which ultimately turned into risk-off episodes.

Today, US real yields are 100 bps+ below estimated equilibrium levels and that implies that monetary and financial conditions are still very loose: the doomsayers might have to wait a bit longer.

11/11