Most people probably get the real interest rate wrong

Spark Global Limited reports:

The textbook will tell you that the real interest rate is the interest rate minus inflation, or the difference between the central bank’s interest rate and CPI inflation. But in fact, when applied to financial markets, real interest rates are more of an expectation, because financial markets themselves are talking about an expectation.

So you’re not looking at what the central bank is doing now, you’re looking at what the central bank is going to be doing in the future, a concept of interest rate expectations. We’re not looking at the current CPI data, we’re looking at a concept of inflation expectations, and there’s a very big difference between inflation expectations and inflation.

For example, if you look at the June CPI figures in the US, they were very high, so you say inflation is very high, that’s a very typical macroeconomic logic, and there’s actually a big problem with that. Because macroeconomic data tend to lag, June’s data were actually for May.

 

So, as a former trader, there is no way to trade published macroeconomic data. The actual data that comes out is actually used to verify, to verify that you made the correct predictions about inflation over the past month.

So how to judge expectations of nominal interest rates? The main loss is to observe the “smartest money” in the market.

Participants in the financial market have different structures, and the participation dimension of financial institutions and the market with large funds is very different from that of retail investors. For example, financial institutions will sink down through primary dealers in the bond market, generating different pricing on the transaction dimension of the bond market.

So when we look at central bank expectations, what are we looking at? You look at bond yields. Of course, when professional investors look at expectations, they also look at the maturity structure of bonds, short, medium or long.

Many people have a misconception that when a central bank speaks, it is very vague. It seems to have both the short end and the long end. What does he mean by that? For example, in the screenshot of the news media, he would say that the Federal Reserve said that the monetary policy would not move at the moment, but it cut the first half of the sentence, which sounds reasonable to you, but the central bank’s speech actually means that I will not move now, but I will move in the future. What is the focus of his statement?

If you just cut the first half, you would think that he doesn’t want to move, but in fact, has the market already priced in, has the market already recorded that he doesn’t want to move, is the market concerned about his future expectations? So listen to the listener, listen to him when he describes his current behavior as well as when he describes his future behavior.

So when we look at expectations, we’re really looking more at the smartest money, and you can understand that the smartest money is the money closest to the central bank system is pricing or what’s going on in the expected market.

So could they be wrong? Of course it does, but it corrects all the time, so you can see that it creates a fluctuation in time, and we can just look at the fluctuation and the trend of the fluctuation and make an estimate.

Inflation is actually an expectation. Where do inflation expectations come from? Watch commodity prices go up? Or am I going to watch prices go up around me? This is not what we mean by inflation in financial markets, especially since it’s very easy to confuse our own perception with inflation in financial markets, with inflation and inflation expectations, so it has to be accurate.

The price increases we feel are certainly inflationary, and it’s always inflationary. However, the inflation you feel in your life and the inflation you feel in the statistics are two different concepts. The inflation in the statistics may not be high, but the price of financial assets is high, and the inflation you feel is high.

We often joke that you have inflation for the poor and then you have deflation. Contraction means income is shrinking, income growth is slowing down, and up means you feel consumption is rising. There is no contradiction between the two.

As for the inflation in statistics, it more describes the back end, which can be understood as the growth rate of household income in the medium and long term. In fact, this is what is directly linked to the inflation in the medium and long term. Of course all economic questions ultimately extend to whether it can change or affect medium – to long-term income growth.

When you talk about inflation, you’re really talking about price transmission in the short term, from upstream to midstream and downstream. There is a pure price rise inside, called stagflation. What do you mean? Is the top price below not to accept. The economics textbook tells you that it doesn’t matter, if the downstream doesn’t pay, the upstream eventually has to lower its price.

This logic is not true in the real world, in the real world there is a special situation, if there is a problem with the supply, there is another situation, which is I will raise the price, I will sell higher, you buy like or not, you don’t buy you can go, I don’t sell. This kind of phenomenon is actually a little stagflation or kind of stagflation.

Essentially speaking, inflation is a phenomenon of demand, so why do we talk about the relationship between income and inflation, while stagflation is actually more of a supply, which is the supply side of the problem. And simple to see goods price inflation, is actually only took a half, because the prices of the goods is determined by supply and demand curve, which is short of normal, if can drive prices to demand the conduction of supply and demand curve, this is called inflation, but the supply and demand curve caused by supply factors among prices, even a form similar to squeeze in the form of a rise, it is stagflation.

So there’s a little bit of a subdivision that you need to do in terms of inflation alone.

Then changes in nominal interest rate expectations and changes in inflation expectations constitute changes in real interest rates. Real interest rate movements are crucial, and this is actually the core that dominates most financial assets.

For financial institutions, the first factor is not the situation of asset investment, but the first factor is the liability end. In short, it’s best if the asset side offers a good rate of return while the liability side changes.

This combination is essentially what we’re saying, if the cost of the debt side gets lower, nominal interest rates are low, inflation expectations imply real returns to the economy are high, then this combination is definitely going to be the most asset-friendly.

But the goodwill goes beyond the asset itself. For example, if you’re investing in stocks, a lot of people talk about value investing, but you know that the price of a stock is not just about value, it’s also about valuation, right? And at the short end, there’s a little bit of speculative psychology going on, and all of those things, together, make up the asset itself, make up the price that you see.

So when we talk about price, instead of just talking about price itself, you should make a distinction between when you’re doing valuation, when you’re doing value, when you’re making valuation money, and when you’re making value money.

What is closely related to the valuation here is actually the liability side. Simply put, the lower the cost on the liability side, the lower the implied real rate of return on the acceptable asset side will be, which in turn will lead to a higher valuation. The reason you’re willing to accept such a low real rate of return is because your debt side costs less.

If your cost on the liability side is 10%, 20%, how dare you accept an asset with an implied real return of 5%? No one would dare do that. The reason you’re willing to accept 5%, or even 3%, is because you have a lower cost of capital.

And this cost of capital is lower, in fact in the middle of the financial market means that the real interest rate is too low. For example, we often refer to excessive liquidity, excessive issuance of money, and then a lot of capital. This concept is actually flow, which is the so-called money in the common people’s understanding.

But it’s not accurate, more money doesn’t mean more on a simple order of magnitude, it has an impact on assets that means the cost of money should be low enough, it actually means the cost of capital should be low. And this cost of capital is not just the nominal interest rate, let’s say the cost of borrowing, these things are called nominal interest rates, but it’s actually the real cost of capital generated by inflation expectations.

For example, if the implied inflation expectation is 2 percent, but the nominal interest rate is only 1 percent, the real cost of money is minus 1 percent. In other words, you will find that if inflation expectations are high, but very low nominal interest rates expected, actually will appear the situation of the real interest rate is negative, once appear negative, there will be a big problem, is all the assets will be typical valuation bubble, are short, you will see the assets are very high.