R*

R*

R* is something that I don’t recall seeing before today, which is probably an indicator that I’m not as fully tuned into the world of global finance, as I like to think I am. R* was mentioned in the Financial Times headlines this morning with the title of “the most important chart in the world”. R* is defined by the Federal Reserve as the natural rate of interest, a rather theoretical concept that gets tracked in most times by the Fed as an indicator of what rate represents the “perfect” interest rate where the economy is, neither hindered, nor overheated by its level. Apparently the Fed has been tracking this hypothetical rate since 1960 and until recently, it has consistently and systematically showed falling natural rates over that entire 50+ year timeframe. The R* rate, which started in 1960 at about 5% fell to almost 0% in 2010. In all fairness, there were times when the rate rose for a while like the mid-60’s, late 70’s and especially the late 90’s, but for the last decade the rate has consistently risen and now sits at between 1-2%.

This demise of the lowering rate environment is both very real, but also is borne out even more convincingly by another rate that is actively tracked by market participants. That is what is called the 10-year Treasury Forward rate or where the market sees the 10-year rate in 10 years, hence known by the handle 10Y10Y. That rate, which is market-driven and not a theoretical fabrication by the Fed, and has been captured since the early 90’s. It shows an even steadier decline for almost two decades from 8% down to 1.5% in 2020, when it started to kick up. In fact, just like with R*, though more recently, there is an unmistakable and steady rise in the 10Y10Y rate for the past three years at a pace that is perhaps twice as dramatic as the fall in rates over the prior thirty years. That rate has now bumped up to about 5%. Please understand that unlike R*, which is a pure rate that eliminates inflation estimates, the 10Y10Y needs to be adjusted for inflationary expectations. That’s what accounts for the difference between 2% and 5% in today’s environment.

But what does all that mean to us chickens in the barnyard? Let’s start by reviewing the interaction of interest rates with the general population. I have discovered that one of the biggest benefits of age is the ability to have perspective over a long period of time. When I started in banking it was 1976 or 47 years ago. At that time, about the only interest rates that mattered to the general public were the passbook savings rates (4% or so), mortgage rates (8.5% or so) and the Prime Rate (6.5% or so). I’m pushing it in saying that most people in the general public even knew what the Prime Rate was. It was the base rate used in the banking world to set the floating rates offered to the best commercial customers. Rates had started to fluctuate a bit more in the early 1970’s as inflation reared its ugly head, headlined by the rising oil prices caused by the creation of OPEC and the decision by the oil producing nations like Saudi Arabia to claim their place in the world by applying modern supply and demand economics to the valuable commodity that lay beneath their sands. But John Q, Public, while hearing about inflation on the news and even feeling it at the gas pumps (assuming it was his odd or even day to even be allowed to buy gas) wasn’t quite connecting the dots on how interest rates played into all of this. Those of us who studied macroeconomics got the joke and even more so, those of us who went on to study finance had a sense of how much the business world revolved around interest rates.

I recall buying my first house in early 1977. It cost all of $64,000, which seemed like a fortune. I used cash held in a passbook savings account earning 4% for the downpayment (I was thinking of moving it into this new-fangled invention offered by Dreyfus called a Money Market Fund since it paid 5%, but there were all these restrictions on withdrawals each month and I needed to get on with my economic life doing things like buying that house. When I applied for a mortgage from a local Savings Bank (that was when banks actually kept their mortgages on their books), I got an 8.5% mortgage for an 85% loan of $54,400. With it came a lecture from the middle-aged female loan officer about how irresponsible I was to saddle myself and my wife with such a heavy burden against our combined $29,000 income (1.88X compared to the published guideline of 2.5X). When I pointed out that lending conventions suggested that I could borrow up to $72,000, she shot me an icy glare and said that she was sure I would find an 8.5% interest rate a big bite out of my lifestyle. The full monthly mortgage payment with principle, and interest, tax and insurance escrow came to $605 monthly or 25% of our gross income, so she was not altogether wrong. By that time in economic history, I couldn’t imagine mortgage rates lower than 8%, and indeed, in a few years they were skyrocketing into the double digits. My personal awareness of interest rates was pretty acute, but the general population only heard about them on the evening news if the Prime Rate went up, even though they had no clue what that meant.

In the early 1980’s I was tasked with building out the bank’s futures and options business for trading in these new esoteric instruments called financial futures, which were starting to trade on the Chicago commodity exchanges. Let me be clear, the main reason for the creation of interest rate futures (the reason I was

Involved) was that interest rates were getting too damn high and people wanted ways to hedge them (which they could sometimes do). To add emphasis to my previous point that the general population still didn’t really understand how interest rates worked and how they really effect regular folks and the economy, the local Chicago floor traders, people who were used to trading commodities, mostly had no clue. One day when the Fed announced that they were doing what is called reverse repo, the trading floor in the T-Bond pit went crazy for a moment. That itself was not unusual, since the same thing would be happening on the NYC cash market trading floors. But just on a lark, I asked the local futures trader what it all meant. He said he had no idea, but that if someone said the Fed was doing reverses, he was supposed to short the futures. He clearly knew nothing about how monetary policy was conducted and how interest rates interacted with the economy.

But now, all these years later, its all different. To begin with we are longing for the good old days of 2% mortgage rates. Also, you can’t NOT be aware of every blip in rates anywhere in the world on an almost instantaneous basis (on cable news and internet alerts) ‘and everyone seems to guide their activities, from buying and selling their houses to making their vacation plans based on interest rates and the resulting currency fluctuations. We have all been raised on a secular trend downward in rates for all these years and that seems now to have changed, and perhaps changed for a generation. In the world of interest rates, one can adjust to and live with low rates and high rates. Falling rates are a pleasure. But rising rates, especially secularly rising rates are a bitch. By my reckoning, the FT may have gotten it right, the R* chart may just be the most important chart in the world.