With inflation hitting 8% by some estimates this past month, this means real interest rates in the US have hit a low not seen since the aftermath of WWII.

Often investors get spooked when negative real interest rates appear since it means they are losing money (in a real sense) by holding onto safe assets like Treasury Bills or T-Bonds. And, many speculate that it is this loss of wealth that forces investors into riskier positions when real rates go negative. We decided to examine this exact phenomena and see how different asset classes do when real interest rates turn negative and stay negative for a protracted period of time.

The long and the short of it — when real interest rates go negative, the riskiest asset classes (emerging market equities, small caps etc) do extremely well in the first half of a negative real rate cycle — outperforming safer assets by over 1.5 percentage points per month. Yet, this outperformance reverses in the second half of a negative real interest rate cycle — on average the riskiest assets underperform by over a percentage point in the second half of a negative rate cycle.

To investigate this issue, I and two research assistants (Jaehee Lee, Natalia Palacios) gathered interest rate data (T-Bills), inflation data and mutual fund return data to various asset classes over the past 50 years. We then examined the seven periods of time over the last half-century where real interests rates dipped negative and stayed negative for more than a month. We then divided up each real interest cycle into a first half and a second half to examine how these different asset classes did over the first half of a negative real interest rate cycle and how this did over the second half of a negative real interest rate cycle.

The first interesting finding is that, during the first half of a negative rate cycle it is the riskiest mutual funds that do far superior. Emerging market funds, US small cap funds, and international equity funds average 1.96%, 1.13%, and 1.03% returns per month, respectively. This is far superior to all other equities and far better than the average bond fund which averages 0.35% per month returns during this period.

Yet, this all flips as time goes on in the interest rate cycle. In the second half of a negative real interest rate cycle, the riskiest funds underperform. For instance, Emerging market funds lose an average of 1.13% per month in the second half of a negative real interest rate cycle. So while investors are seeking risk in the first half, it appears they are quickly running away from it the longer the US remains in a negative real interest rate environment.

Please read the rest at:

https://www.wsj.com/articles/investment-negative-interest-rates-11651781476?mod=latest_headlines

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