It's The Real Interest Rate That Counts
John Mauldin's Outside the Box

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Today's "Outside the Box" will feature an essay by good friend David Kotok of Cumberland Advisors. In his article, David discusses what the development of a global economy means for currencies and the financial markets. He distills the foreign exchange markets into 4 major countries and explains both the policies and risks faced by the central banks of these nations, and how they affect you.

David R. Kotok co-founded Cumberland Advisors ( in 1973 and has been its Chief Investment Officer since inception. David's articles and financial market comments have appeared in The New York Times, The Wall Street Journal, Barron's, and other publications. He has also appeared on CNN, CNBC, and Bloomberg TV. David is also one of the organizer's of the annual Shadow Fed fishing weekend each summer which I am privileged to get to attend.

I hope that you find this article to be both educational and thought provoking.

John Mauldin, Editor

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BOJ, BOE, ECB & the FED: It's The Real Interest Rate That Counts!

By David Kotok
January 16, 2007

If you want to understand financial markets and global economics, it's the real interest rate that counts.

First a definition from Wikipedia: The "real interest rate" is the nominal rate of interest, adjusted for compounding, minus the inflation rate. Since the inflation rate over the course of a loan is not known initially, volatility in inflation represents a risk to both the lender and the borrower. Readers may wish to read the full discussion about real interest rates at Wikipedia. It is written in lay terms and non-mathematical.

Let's set forth the method we use to support our argument real rates.

At Cumberland, we estimate the real interest rate for the bulk of the monetary world. When we look around the world, we find that most of the international monetary activity is conducted in only four currencies, yen, US dollar, British pound and euro. As a practical matter, it is only those four currencies that count. Most of the others are either pegged to one of them or managed by a government in a relationship to one of them.

In each of the four currencies, there is a tradable inflation-indexed bond (TIPS) issued by a government of high credit quality. Japan, UK and the US are obvious. France is the large issuer of euro-denominated TIPS. The definition of inflation is a little different among these four TIPS bonds but not enough to alter our argument. Most of the inflation calculations around the world are catching most of the changes in prices. There is a little distortion due to oil price changes and how they are treated. At Cumberland, we assume that they are all close enough for our purposes.

Now that we have a market-based pricing reference for global real interest rates, we can also calculate the global expected inflation rate. To do that we simply take the interest rate on the nominal yield of the corresponding government bond in each currency and subtract the real rate (TIPS) from it. The difference is the inflation expectation priced into the market.

The next part is a little more complicated but necessary in order to understand why all money is global. We will try to simplify.

It is presently possible to place money in any of these four currencies even though the one chosen is not your own home-biased choice. Here is an example. Let's say you are an American and your base is the dollar. You can get 5% right now in your bank. But you also have the ability to go abroad. Your can convert your dollars to euro and then deposit the euro in an international bank. Today you will get a lower interest rate on euro deposit but it doesn't end there. You can also buy a futures or derivative currency contract that establishes the exchange rate in the future when you will convert those euros back into dollars. Take the exchange rate contract and the interest rate together and net them out. Now compare the net interest rate you get in dollars vs. the net money you will have from the euro deposit plus the futures contract. Do this exercise as of the date when all is closed out at maturity. Whichever is the highest net number of dollars for you is the best choice for you to maximize your return. Most cash managers for most multi-national companies do this every day. So do most global financial institutions.

As you can see, we have the mechanism in place. Our globalized world is not only just goods and services. We are globalized in finance as well.

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How does it work? What's an actual example of market forces?

On any given day the futures contracts and the world's interest rates are arbitraged to within a few basis points. Earning those arbitrage pennies is a full time job for a lot of folks. The market is efficiently priced. Arbitragers will go long or short either side of the trade whenever it is out of equilibrium.

Any event in any one of those currencies immediately impacts all four of them. Witness what happened when the Bank of England surprised the market with a 1/4 point rate hike on January 11th. Every interest rate and exchange rate adjusted at once. Global arbitragers made sure of it. The same is true when Bernanke speaks about Fed policy or when the Trichet worries about euro zone inflation.

Let's not forget Governor Fukui. Japan is expected to hike a ¼ point this week. It is nearly all priced into the market. Those who are forecasting a shock reaction like the one we had last May are going to be disappointed. World markets are poised to rally on this news, not sell off.

Now let's get back to the Bank of England. That linkage was discussed in the Barclays daily currency analyzer on January 15, 2007. Here is the quote: "The fall in EUR/GBP spot (-2.1%) was in line with FFV (-2%), driven by 3 month Libor spread changes (-2.4%) following the surprise rate hike by the MPC. Priced fat tail risks for GBP had jumped to historical highs in the preceding weeks."

Email me ( and I will send you the whole document. Warning; it is quite technical.

Let's translate the Barclay's shorthand into English: the decline in the spot market exchange rate between the euro and the British pound (minus 2.1%) was consistent with the forecasted change of the Barclay's "financial fair value" (FFV) quantitative model. It was predicted from the changes in the three months London Inter Bank Offered Rate for these two currencies (minus 2.4%). That change occurred in response to the surprise 25 basis point (1/4 of 1%) interest rate hike by the Monetary Policy Committee of the Bank of England. Prior to that hike the market had developed anticipatory pricing of a rate hike. Markets expected the higher rate but had great uncertainty as to timing. Therefore, markets priced a higher than usual risk of a large movement or change in the difference between the dollar vs. pound in the shorter-term maturities.

As the example above shows, the adjustment mechanism takes place in the futures market prices and in the spot exchange rate. In this case, markets correctly anticipated the Bank of England rate hike but failed to anticipate the timing. According to CNBC, only 1 out of 50 forecasters had the timing right. Nearly all had the direction correctly forecast. Barclay's quantitative model is attempting to capture these anomalies.

The global finance paradigm is working. Central banks are credible.

Please note how the adjustment was pronounced in the foreign exchange (FX) pricing. FX is (1) the location of and (2) the adjustment mechanism used in our present globalized financial paradigm. That is why exchange rates seem so volatile.

We should not be alarmed by this new paradigm. In a global sense it is an orderly adjustment mechanism, even when changes are sometimes abrupt. It is transparent. It is transacted in a free and liquid 24/7 market. Orderliness, transparency and free market pricing are three of the reasons why risk premiums on bonds are smaller now than they were a few years ago. This is also true for other related financial market asset classes.

When anyone attempts to alter this freedom, the markets are brutal in their punishment. That is why Thailand's stock market fell 20% in one day when the government tried to impose currency controls.

We know the weights of the world's debt when measured by the currency in which that debt is issued. And we know the real interest rates in each currency. And we know that the market is adjusting at once for each new piece of information. And we know that we can match maturities with derivatives to pick any point on the maturity spectrum that we desire. All this enables us to construct a global real interest rate curve and to monitor it every day.

If we look around the world today we see the global real interest rate curve is flat. On a weighted basis the short term real interest rate is slightly above 2%. We weight by the balance of outstanding debt in each currency. By using the TIPS trading in each currency, we can estimate the globally weighted and market priced real bond interest rate. It too, is slightly above 2%. The real interest rate curve flatness suggests that the world's four major central banks for the four key currencies have successfully achieved their sought after transparency. They are collectively credible. They are targeting inflation explicitly or implicitly. Either way, the market believes them.

What does this mean for investors?

A 2% global real interest rate means a lot for financial markets. To determine how much we must compare it with the global real growth rate. This part takes some forecasting but is reasonably easy to estimate.

The world is expected to grow about 4 ½% in 2007. That is a little lower than the 5% rate we saw in 2006. The distribution of the 4 ½% growth is something like 2 ½%-to-3% in the US, 2%-to-2 ½% in developed Europe and 7%-to-9% in the emerging market countries of the world. China is the largest of these but the composite of the entire world is important. This is not just a China story. Emerging markets include countries in Latin America, Central Europe and Asia. And let's not forget the oil rich states in the Middle East.

The financial result is predicable in a world where the real growth rate is 4 ½% and the real interest rate is 2%. Money will move from the lower bond rate to the higher growth rate. In this case that means the move is from lending to the ownership of entrepreneurial business. For investors that means stocks traded on the world's exchanges. For venture capitalists and private equity folks that means operating businesses. This phenomenon explains the current trend of borrowing money to go private or to buy a division of a public company and take it private. Such movement is not just running from Sarbanes-Oxley reporting requirements. It is running to the higher return on investment. Financing at a 2% real rate to get a 4% real rate of return is a no-brainer. It is a double of your investment return outcome.

Since the higher growth rates are in the emerging markets we see the phenomenon of the higher returns there as well. The US stock market returns were in the mid-teens last year if you were a US dollar based investor. If you were based in the euro the returns were near zero. The developed country returns in the world for a US investor were in the 20s and the emerging market returns were even higher. Sure an American got the currency kick last year. But you also got the higher growth rate abroad and that is why those international markets did so well.

How long can this continue?

Eventually the real growth rate and the real interest rate have to converge closer to each other. Free markets will do that over time. More and more borrowing will occur at the low real interest rate and the proceeds will be applied to investment in the higher real growth rate. The borrowing will raise the real interest and the application of the money will bid up the prices of the entrepreneurial assets and therefore lower the growth rate obtained for each investment unit. The growth is still there but the price is higher so the return for each investment diminishes.

We are not there, yet. In fact, we are a long way from convergence which reaches closure. Trillions could move into the growth areas before the valuations reach a level where the real interest rate and the real growth rate get close. While this bodes well for stocks, it has warning implications for bonds. High grade bonds around the world are priced in relation to the real interest rate and the expected inflation rate. We must address each of them separately.

We have argued that the global real interest rate must eventually rise absent a global growth slowdown of monumental proportions. The other component of the bond yield is the inflation expectation. This is in the hands of the central banks. As long as they maintain the present transparent policy and continue to be credible, the outlook for the inflation component is reasonable. That means bond yields will only gradually rise. In the US we expect the 10-year treasury yield to rise into the low 5% range but not much higher.

What are the risks?

The problem for bonds is that the current global yield structure has little margin for errors. The central banks of the world must execute policy with near perfection. That is a tall order for the practitioners of an inexact science. Any mistake can be costly. And only one central bank needs to make it and all currencies and interest rates are immediately impacted.

Herein is a new risk. In the old models of closed economies each central bank could look within and deal with domestic issues without regard to the rest of the world. Most central bankers still have this bias. In the globalized world they have to look beyond their borders. That is the new paradigm in the world. It is also untested and will remain so until there is a significant shock.

Risks to this outlook fall in two categories of shocks. There are the natural ones like bird flu, tsunamis, or weather. Central bankers cannot do anything about them. They can only temporarily ease the burden after the shock occurs.

The other risks are manmade and, hence, maybe more dangerous. They fall into two categories. First, there are the bad actors. We can all name them using varied languages, whether Arabic, Spanish, Korean and others. Those folks constantly make headlines. Today's news features Chavezajihad.

Secondly, there are the policy mistakes of politicians. Perhaps that is the biggest danger of all. Protectionism, barriers, tariffs, locally directed anti-competitive subsidies are the stuff which can derail this marvelous global growth experiment. Here vigilance is in order and movement of portfolio exposure must be quick in response. This is true in places like Thailand and equally true in the United States. Regrettably, we must say that some of our politicians are not much better than those in many other countries of the world.

Let's sum this up.

Low real interest rates and higher real growth rates mean good things for stocks. They also mean the outlook for bonds is more problematic. Risk can be assessed but must be monitored closely. Central bank credibility is paramount but must not be taken for granted.

At Cumberland, we remain fully invested in stock markets around the world using exchange-traded funds (ETF). Our managed bond portfolios are at neutral duration because of the macro risk that the global real interest rate is destined to rise.

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There is one final risk element specific to the United States.

The peak core real interest rate in the US has been trending lower. This has been apparent during the last 25 years as interest rates and inflation rates fell from the double digit era a quarter century ago. This leaves us with an unanswered question: should we use the average or the trend?

That real rate peaked around 7% prior to the 1974-5 recession. It peaked there again (7%) when Paul Volcker attacked inflation in the 1980-81 recessionary period. It peaked at 5.5% before the 1990-91 recession. It peaked at 4% in advance of the 2001-02 recession. Today, the US real interest rate is around 2.4%-to-2.5% depending on how you measure it. If we use the downward trend of the last 25 years, The US economy is near the point where a recession will be triggered. If we use the average of 5.5% for the last 40 years, the real rate is way below the average and should not trigger a recession.

We thank Credit Suisse for this data. They use the average. We are not sure which method is correct.

Also, globalization and this new paradigm did not exist until quite recently. We are just learning about its benefits. We are also just learning about its risks.

The jury is still out on this real rate peaking indicator. At Cumberland, we believe that a real interest rate of 2 ½% is too low to trigger a full recession. In our view it will only bring the growth rate to trend and that is exactly what we have seen to date. At Cumberland, we also believe that a real rate of higher than 3% would be enough to alter this view. If we saw a credible move to a 3% real interest rate, we would begin to buy TIPS and to lighten our allocation to stocks.

History gives us no guidance here. Stay tuned.

David R. Kotok, Chairman and Chief Investment Officer


Your always keeping an eye on inflation analyst,

John F. Mauldin


John Mauldin is president of Millennium Wave Advisors, LLC, a registered investment advisor. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions.

Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staffs at Millennium Wave Advisors, LLC and InvestorsInsight Publishing, Inc. (InvestorsInsight) may or may not have investments in any funds, programs or companies cited above.


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Posted 01-22-2007 4:04 PM by John Mauldin