What is r-star?
Conceptually, the equilibrium real rate (also known as the neutral or natural real interest rate, often denoted as r*) is the theoretical interest rate consistent with stable inflation and full employment when the economy is neither expanding nor contracting. It serves as a benchmark for central banks because it indicates whether monetary policy is stimulative or restrictive.
To understand how markets are positioned relative to central bank expectations, investors need a real time estimate of the equilibrium real rate as perceived by market participants. Alongside long-horizon inflation expectations, they provide an anchor point for the yield curve. These two ‘macro trends’ are important drivers of asset returns, especially for long-duration assets. The importance of the equilibrium real rate is matched only by the difficulty of obtaining accurate and timely estimates. We take the investors’ perspective and focus on estimating market perceptions of the equilibrium real rate. To this end, we have advanced yield curve modelling tools that allow us to extract the equilibrium real rate at a daily frequency.
Knowing the evolving market consensus on the structural forces driving real yields is a prerequisite for interpreting yield moves. Without a timely estimate of the equilibrium real rate, it is impossible to understand the market’s view on the stance of monetary policy and the term premium, and thus to relate yield curve moves to macro drivers.
Our estimates of r-star
We extract the market consensus on the equilibrium rate by combining multiple sources of data including yield curves, professional surveys, inflation derivatives and Fed dot-plots. These data are used to extract the estimates of the equilibrium real rates at a daily frequency.
A key feature of our estimates of the market consensus on the equilibrium real rate is that they are consistent with market pricing. This means the estimates align with the remaining components of the yield curves — monetary policy, inflation expectations and term premium – providing a coherent breakdown of what’s priced into rates.
The chart below shows historical estimates of market-perceived equilibrium real rate for the US together with the 5Y5Y forward real yield which is a common gauge of longer-run real rate expectations derived from inflation-linked bonds and is often interpreted as the market’s view of r-star. Our estimate of the equilibrium real rate cleanly captures the broad slow-moving trend in real rates while the 5Y5Y forward real yield is much more volatile because it contains transitory variation in real rates and term premium, and as a result not a suitable indicator of the long-term level of real rates. Also, there is a large discrepancy between our market-implied r-star and the real forward rate until late 2011. Our estimate declined substantially during the Global Financial Crisis (in line with the economic intuition) while the real forward rate stayed high for another three years – driven mainly by an elevated term premium.
Source: Allocation Strategy calculations, Federal Reserve Board
Unlike many other approaches that estimate r-star, we do not use realised macro data such as output growth or inflation in the estimation. Besides its lower frequency, macro data can be significantly revised and also can take extreme values such as during the Covid-19 pandemic, distorting r-star estimates.
How do investors benefit from timely estimates of market-implied equilibrium real rate?
Our estimates of market-implied equilibrium real rates add value to investors in several areas:
Asset allocation
Estimates of the equilibrium real rate are a key driver of expected returns across all asset classes, and their importance grows with the horizon for which the expected returns are estimated. R-star determines the long-term level of the risk-free rate assumptions.
Tactical macro
Timely and accurate estimates of the equilibrium real rate improve the forecasting performance of yields, help anticipate central bank moves and thus help form sharper tactical macro positioning.
Interpreting yield curve moves and estimating term premiums
Precise estimates of r-star are a prerequisite for decomposing the yield curve moves and attributing them to underlying macro drivers. Also, without accurate estimates of r-star, it is impossible to obtain unbiased estimates of term premium.
Macro scenarios and risk management
Distinguishing between transitory and persistent moves in real rates makes macro scenarios richer and more precise. Being able to do this, allows investors to better manage interest rate risk exposures more effectively and more holistically across all asset classes.
We provide daily estimates of market-perceived equilibrium real rate for the US, euro area and the UK markets, with more markets coming online soon. The estimates are part of the Market-implied Macro solution.
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