Understanding Interest Rates Impact

Long rates are drifting higher led by real rates (chart). It’s not a problem for now - the narrative is still inflation falling, growth holding up, and cuts coming - until it is, and this is why - Long term #neutral rate has most likely gone up. Because of greater #fiscal spending, and higher rates needed to stop economy from overheating. To contextualise with numbers: fiscal stimulus boosted growth through pandemic but it also meant the US fiscal deficit widening from 3.5% late 2022 to nearly 8% now (even adjusting for student loan write-offs). It will go down a bit but not to pre-pandemic levels: for example aging population will pressure social security and healthcare spend (CBO projects a 50% increase over 20 years). US debt could rise from 123% of GDP now, to 150% by 2030 and nearly 200% by 2040. It means debt servicing could exceed Medicare budget within next few years. Practically it means we are #RiskOn now but we need to be very nimble when narrative goes from “immaculate disinflation” to “higher for longer”. It also means a preference for front end and belly of the Treasury market over long end because it is a matter of time term premium returns. I look forward to speaking to our international clients in 30 mins and US clients later today about the release of our Q2 Global Outlook.

Macro 101: What’s R*, the real equilibrium interest rate? When setting interest rates, Central Banks aim to achieve price stability (and in some cases also maximum employment like the Fed). To do that, they need to calibrate rates around their interpretation of neutral: raise rates above this level if you need to cool down the economy and price pressures, and cut rates below neutral if you need to stimulate the economy. This is why Central Banks use the concept of r* or real equilibrium interest rate. R* is the estimated real rate at which the economy doesn’t overheat or excessively cool down. The chart below shows r* in the US is estimated to be around +1%, which means that if core inflation sits at target the nominal neutral rate would be 3%. Given inflation has been running above target for years now, the Fed is applying a somehow restrictive policy with Fed Funds at 4.25% (above neutral). But what are the inputs Central Banks use when calculating r*? 1) Demographics: a bigger labor force means stronger potential growth and a higher equilibrium rate and vice versa 2) Productivity: a more productive use of capital and labor implies a higher equilibrium Rate and vice versa 3) The availability of risk free assets: an ample supply of risk free collateral implies higher equilibrium rate and vice versa Yesterday’s Fed minutes showed some FOMC members believe r* has increased given the persistent use of deficits (more supply of Treasury collateral) and AI-driven productivity gains. This would make the Fed 4.25% rate not so restrictive as neutral would be seen higher at around 3.50%. What do you think? 👉 If you enjoyed this post, follow me (Alfonso Peccatiello) to make sure you don't miss my daily dose of macro analysis.

EndGame Macro: A major shift is underway in global bond markets, and it’s starting in Japan. Japanese life insurers some of the largest institutional investors in the world are now selling Japanese government bonds (JGBs) at the fastest pace on record. Why? Because their duration gap has turned sharply negative for the first time in modern history. The duration gap measures the mismatch between the interest rate sensitivity of assets and liabilities. A positive gap means an insurer’s assets (like long-term bonds) respond more to rate changes than their liabilities (like annuity payments), which is generally manageable. But now, the gap has flipped to −1.48 years, the lowest on record. That means rising interest rates are hammering insurers: their liabilities are becoming more expensive faster than their assets can keep up forcing them to unwind long-duration holdings to stop further P&L damage. You can see this in the chart that from 2016 to 2020, insurers comfortably held a 4–5 year positive duration gap. But that edge eroded as Japan’s long-term yields rose and BOJ Yield Curve Control lost credibility. Now that the 30-year JGB yield has breached 2.75%, these insurers are facing mark-to-market losses and they’re being forced to sell into weakness. The second chart shows the result that net JGB flows from Japanese life insurers have plunged into deep negative territory through early 2025. This is not a tactical rotation it’s a systemic duration de-risking event, and it’s happening in the world’s most tightly held sovereign bond market. Why this matters globally: •Japanese lifers are major holders of U.S. Treasuries, European sovereigns, and global credit. If they’re de-risking at home, they may need to sell foreign assets too, creating ripple effects across global bond markets. •A withdrawal of Japanese capital means fewer buyers for long-duration debt at a time when the U.S. and Europe are issuing record amounts of it. •It signals the limits of central bank yield suppression. The BOJ may be forced to step back in with stealth QE or risk a bond market crisis. •It also injects volatility into FX markets particularly USD/JPY as capital flows repatriate or hedge mismatches widen. Bottom line: This isn’t just about Japan. It’s the leading edge of global duration stress. The BOJ’s failure to maintain policy control is forcing private capital to do what central banks fear most exit long duration at scale. The Japanese lifers are the canary. If this continues, other markets will follow. Watch the yield curve, watch FX hedging costs, and most of all watch what they sell next.

Treasury yields are never just one number—they’re three stories at once. Using August 2025 as example, the 10-year Treasury at 4.23% breaks down into: A • 2.38% expected inflation • 0.97% expected real short rate (R*) • 0.88% bond risk premium That’s the real anatomy. Two-thirds of the yield is about inflation credibility. The rest is growth equilibrium and investor sentiment toward long bonds. History matters. From the 1980s to 2020, all three components fell—driving the great bond bull market. Post-2021, it flipped. Inflation expectations stayed anchored, but real rates and premia moved back into positive territory. That’s why bonds finally pay a real yield again, but their diversification role is weaker. Here’s the friction. Investors who still think of Treasuries as “return-free risk” are behind the curve. With ex-ante real yields near 2% and premia close to 1%, bonds contribute to returns again. But if inflation expectations de-anchor, the hit is double—yields climb, correlations flip positive, and the hedge role disappears. Global data shows the same pattern: higher real yields and premia driving the shift everywhere from Germany to Canada, with Japan as a partial outlier. Diversification isn’t dead—it’s just not as simple as “own bonds and you’re safe.” Portfolio takeaway: • Treasuries are investable again—don’t ignore them. • But they’re not a perfect hedge—pair them with other diversifiers like gold, trend, or alts. • Think global, not just U.S.—the repricing is worldwide. Would you treat bonds as a return engine or a hedge in this cycle? If inflation expectations break higher, how does your allocation shift? Do you diversify bond exposure globally—or concentrate in the U.S.? What’s your alternative hedge if Treasuries fail? For more see our Nomura CIO Corner: https://lnkd.in/e4TCax_g #Treasuries #BondMarkets #Yields #Inflation #Diversification #Nomura #CIO #Macro #Markets

Market watchers know how the dollar has decoupled from Treasury yields. But what does it mean for emerging markets? The first part - a weaker dollar - is an obvious EM positive. It typically eases dollar debt servicing, helps trade, supports capital flows, boosts investor returns …although not all EMs are helped equally, nor is rapid dollar depreciation in anyone’s interest. Caveat emptor Suddenly, the macro set up looks good for many #emergingmarkets = weaker dollar + better relative growth prospects + low energy and food inflation + policy stimulus in Europe and China A new problem for EM maybe rising DM bond yields. So how should investors weigh up a higher US term premium versus all the other good stuff? 1️⃣ recent history shows a few phases where the dollar is weakening, term premium are elevated, and EMs are still outperforming. For example = late 2003-2004 , or 2006-early 2008 2️⃣ EM performance drags from higher US yields are principally about tighter financial conditions. But many EMs have transformed their macro structures since the “fragile 5” phase a decade ago. EM economies have macro de-risked 3️⃣ EMs are oxygenated by a weaker dollar. And faltering confidence in American exceptionalism boosts investor interest now. Plus that shift away from dollar credit to local FX funding, minimises the headwind from TSY bear steepening 4️⃣ another important theme is how some EM and Frontier markets have become less “global”, and more “local”. For example, some EMs are taking advantage of the new policy space of a weaker dollar to cut rates - Indonesia, Mexico, Poland …or Egypt , just last week ➡️ and more idiosyncratic behaviour in EMs could be something of a “silver lining” for investors …particularly useful in the new, supply-shocked macro and investment regime #economy #investing #markets

Rising rates are good for bonds in the long run. That is one of the most misunderstood ideas in fixed income. When rates rise, bond prices fall. Everyone sees that part. What gets missed is that higher reinvestment rates offset the price shock over time. If you hold a bond portfolio long enough, the pain from the rate increase is gradually healed by the fact that you are now earning more income. That is why the starting yield matters so much. Bond investors tend to worry about rising rates because of the short-term losses. But as I explain in Beyond Diversification, the impact of rising rates on bonds is both bad in the short run and good in the long run.

Despite some short-term relief from month-end rebalancing, we believe that government bond yields face upward pressure over the medium term from a supply/demand perspective. There are two duration shifts that present a headwind for government bonds over the medium term. The first duration shift has been taking place in demand and has to do with the retail impulse into bonds. The YTD pace in bond funds is tracking pace of around $450bn-$500bn, a sharp decline from the $1.36tr seen in 2024. The picture looks even more problematic for bond demand if one takes into account the duration impulse. Not only have bond fund inflows slowed sharply this year relative to 2024 but these inflows have shifted away from longer duration government or corporate bond funds towards short duration funds. In other words, there has been an even bigger decline in bond fund demand in duration terms. The second duration shift has been taking place in supply. While the duration impulse of corporate bond issuance has been flattening out as corporates reduced sharply the maturity of their issuance, the duration impulse of government bond issuance continues to rise widening its gap with corporate bond issuance. This is shown in the chart below which depicts the notional amounts of USD corporate bonds in 10y-equivalent terms along with the equivalent metric for the Treasury excluding Fed holdings. In other words, much of the duration supply has been stemming from government bonds rather than corporate bonds.

Real yields continue to climb as nominal interest rates increase while core PCE inflation decreases. This dual pressure has caused real yields to rise over 300 basis points in the past 12 months. Real yields are far more important than nominal yields in judging whether interest rates are restrictive or not. To illustrate this, consider the fact that a 4% nominal interest rate in a 7% core inflation world would encourage further borrowing rather than restrict it. As core inflation continues its downward trajectory, real rates in the United States will likely get even higher - and hence more restrictive. There is a scenario in which the Federal Reserve may have to begin cutting interest rates - not to be accommodative - but simply to avoid becoming more restrictive in real terms than they already are.

Long-duration US Treasury bonds have plummeted by a jaw-dropping 46% since March 2020, marking one of the most significant financial events in recent history. 🤔 𝐖𝐡𝐲 𝐃𝐢𝐝 𝐈𝐭 𝐇𝐚𝐩𝐩𝐞𝐧? The Federal Reserve's aggressive rate hikes, aimed at curbing inflation, have been the primary catalyst. As bond prices and yields move inversely, the surge in yields led to a sharp decline in bond prices. The 10-year Treasury note's yield alone skyrocketed from <0.7% in March 2020 to >3.5%. 🌐 𝐈𝐦𝐩𝐥𝐢𝐜𝐚𝐭𝐢𝐨𝐧𝐬 𝐟𝐨𝐫 𝐆𝐥𝐨𝐛𝐚𝐥 𝐌𝐚𝐫𝐤𝐞𝐭𝐬, 𝐈𝐧𝐜𝐥𝐮𝐝𝐢𝐧𝐠 𝐈𝐧𝐝𝐢𝐚: Global Ripple Effect: The U.S. bond market's tremors can send shockwaves across global financial landscapes, potentially affecting asset valuations and investor sentiment worldwide. Indian Markets at Crossroads: Indian investors with diversified portfolios, including U.S. assets, might feel the heat. Moreover, global economic shifts can influence foreign investments, trade dynamics, and currency movements in India. 🔮 𝐎𝐮𝐭𝐥𝐨𝐨𝐤: While the immediate aftermath is turbulent, it's essential to see the bigger picture. Bonds, traditionally the 'safe havens', might undergo a perception shift. Investors globally, including in India, will need to: ✅ Re-evaluate their portfolios, considering the changing dynamics. ✅ Diversify investments to include Equities and Commodities mitigate risks. ✅ Stay informed and be prepared for potential market volatilities. The financial landscape is evolving, and so should our strategies. 📈 #GlobalFinance #IndianMarkets #BondCrash #FinancialOutlook

RBI's repo rate cuts have seen only partial transmission thus far: Foreign Banks cut lending rates most (34 bps on outstanding loans), #PSBs & Pvt Banks less (10-19 bps) esp on fresh loans & deposits. Customers of the banking system need to wait longer for the benefits of RBI's rate cuts to accrue to them. In fact, Pvt Banks raised fresh deposit rates by 20 bps The transmission of interest rate cuts by banks has been low despite RBI cutting rates with alacrity due to several factors including: - Liquidity: Excess liquidity in the system can reduce banks' reliance on RBI funding, diminishing the impact of rate cuts. - Risk aversion: Banks may be cautious in lending, prioritizing safer investments. - There are also inbuilt rigidities in bank asset-liabilities that affect transmission of rate cuts : 1. Sticky deposits: Banks often don't pass on rate cuts to depositors to maintain deposits and avoid losing customers. 2. Existing loan portfolios: Fixed-rate loans or long-term loans with fixed interest rates limit immediate transmission. 3. Asset-liability mismatch: Banks' assets (loans) and liabilities (deposits) have different interest rate sensitivities. However, in contrast, when policy rates rise, transmission is faster as - Banks quickly pass on higher rates to borrowers. - Depositors expect higher returns. #monetarypolicy #rbi #interestrates #transmission #banks #deposits #lending