It’s tempting to dismiss the whole concept of R*, or R-star — the supposed “natural” level of interest rates that serves as a target for much of the central banking world — as yet another pointless theoretical construct by economists suffering from an acute degree of physics envy.
Tempting, and correct. The idea of a pseudo-perfect neutral interest rate level that neither stimulates nor slows a strong economy with stable inflation is an attractive academic proposition but when has that ever actually happened in practice?
Even Federal Reserve chair Jay Powell once compared using R* to guide monetary policy with navigating by stars that keep moving around the sky. At the Jackson Hole conference of central bankers last week, he added that the sky was also cloudy. Given that, R* hardly sounds like a lodestar we can rely on.
Highlighting the messiness, the New York Federal Reserve — led by a guru in the field, John Williams — suspended its calculations for R* during the pandemic, and when it resumed publishing updates last May it was with a revised model and rejigged history. Which, as Robin Brooks, chief economist of Institute of International Finance, observed, is a bit like an investor tweaking their historical returns to make them look better. “Not cool,” he tweeted.
R* still matters because a lot of influential central bankers think it does. It kind of signifies where they think interest rates should theoretically end up in the long run — even if history pretty clearly shows that in practice they tend to go up until something breaks and then go down until it heals.
But anyway, there is actually a decent proxy for what the market thinks the long-term “neutral” level of interest rates are. More accurately — and perhaps more importantly — it shows the market’s view of long-term bond yields. And over the past year, it has repriced dramatically. This is the 10-year, 10year Treasury forward rate.
It’s derived from the curve of US government bond market yields over time and shows what investors think the 10year Treasury yield will be in a decade.
After haphazardly sagging for several decades, it plummeted to a record low of about 1.6 per cent in the wake of the pandemic. But over the past year it has rebounded to about 5 per cent — indicating that investors think that 10-year Treasury yields will edge higher and remain elevated for the next 10 years.
Its long-term nature strips out a lot of noise and makes it a decent shorthand for what investors reckon R* is, albeit with some caveats.
It’s obviously just a nominal rate. You have to plug in some kind of implied or assumed inflation rate to get you to a “true” market-implied R*. It’s also not the most liquid market in the world, which is why a lot of people prefer fiveyear, five year interest rate swaps.
Moreover, Barclays’ Ajay Rajadhyaksha points out that the 10-year, 10-year tends to be heavily affected by whatever 10-year and 20-year Treasuries are doing — and 20-year Treasury yields tend to act funnily, given the awkward maturity (it’s currently yielding more than the 30-year).
However, instead of being merely flawed proxy for the market’s view of R*, the 10-year, 10-year can be seen as a “cleanish” indicator of what the bond market thinks its own long-term future looks like.
It is now showing that the long era of low interest rates has passed on. It is no more. It has ceased to be. It’s bereft of life. It rests in peace. It’s hopped the twig, kicked the bucket, shuffled off its mortal coil, run down the curtain and joined the great fixed income market in the sky.
Just a few years ago, the 10-year, 10year was signalling that investors thought “low for longer” had become “low forever”. Today it is whispering that bond yields will still ebb and flow but we will not return to Ye Olde days of zero rate policy for a generation.
Of course, it’s hard to ignore the fact that the 10-year, 10-year has also been comically wrong for quite a while — both consistently underestimating how far the low-yield era would go and then overestimating its durability just as things changed in 2022. But unlike R*, the 10-year, 10-year is an actual, real rate with a signal and practical consequences.
You could even make the argument (albeit mostly for the hell of it) that it’s even more important than whatever the actual 10-year Treasury note is doing, given how perceptions of the future can shape investment decisions today. It’s going to be interesting to see if this is just another headfake or whether we really are in a new, durable mid-yield era.
A version of this article appeared first on ft.com/alphaville