Before the pandemic, long-term real rates of interest had been on a downward trend, globally, for decades. There was a growing consensus among economists that they knew why: demographics. Not only was the balance between old and young shifting in favour of the old, as birth rates fell, but people were living for longer, spending a greater period of their lives in retirement. These two effects combined to generate a substantial increase in the demand for assets, in preparation for perhaps 20 years or more of life without work, against largely unchanged supply, pushing equilibrium real rates of interest sharply lower. The decline in long-term real rates of interest was used to justify asset valuations that otherwise looked stretched, including high price-to-earnings ratios for major equity indices, and high house prices relative to incomes in many major economies. As our chart shows, in the UK at least there has been a dramatic reversal of that long-term downward trend. Since the beginning of last year, close to one half of the 700-basis point decline in UK long-term real rates of interest has been unwound. A part of this will reflect expectations of tighter monetary policy, but not all of it. Real rates of interest have risen across the curve. And it is not just a UK phenomenon. Since the beginning of last year, long-term real rates of interest have risen by 225 basis points in the US, for example, 220 basis points in Germany and 180 basis points in France. It is unclear why the increase in long-term real rates has been so dramatic when the demographic picture is largely unchanged. If sustained, it may challenge valuations across many asset classes.
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