Structural breaks in long-term real interest rates

In the rarefied heights of econometrics, a structural break in a time series takes place when there is a change in its mean and/or other parameters of the process that generates the data.1 In common parlance, it is an occurrence that results from a shift in fundamentals, which can be large or small, gradual or abrupt. Admittedly, the jury is still out because there is an awful lot of statistical testing of hypotheses going on, but the sharp fall and the subsequent bounce back of long-term real interest rates in some advanced economies is a serious candidate for being one of such events (Chart I).

The Global Financial Crisis (GFC) of 2008-9, the taper tantrum concerning monetary policy in the U.S. in 2013-14 and the pandemic of 2020-21 were transitory adverse shocks that eventually faded away. However, the way America and Europe reacted to them, as well as their performance afterwards – an embarrassingly slow recovery amid rising inflation pressures – strongly suggests that a fundamental change in parameters occurred, insofar that long-term interest rates adjusted for inflation have shifted upwards. To be sure, the evidence supporting this hypothesis in the U.S. is quite compelling, although its scale and the reasons underpinning the shift are still debatable.2 Therefore, if a critical factor in the process of portfolio allocation and investment is showing instability in those developed geographies, inferences based on past considerations of economic growth, inflation, foreign exchange movements and asset returns, to number but a few key related topics, are now inconsistent with the new environment.

But is that instability a global phenomenon? There are rational grounds to assume that a transition to higher long-term real interest rates is also occurring in other geographies that are highly integrated with the U.S., although the paucity of reliable and comparable time series warrants caution in interpreting the results. In Latin America, for instance, the high volume of trade and financial flows between Mexico and America causes the correlation between them to be of the same order of magnitude of Europe’s (Chart II). On the other hand, there is a robust negative correlation between Japan, a developed nation, and the world’s largest economy, which suggests no structural break whatsoever in that Far East country. Indeed, since 2015 the Japanese market seems to be trapped in a negative yield universe that not even the inflation noise post-COVID-19 could change.

So, there is no single script for a possible transition to an environment of higher long-term real interest rates and most countries should be in between the two extreme situations of high connection with the U.S., which increases that probability, and negative correlation, which rules it out. Against this backdrop, it is instructive to assess the latest events in Latin America’s largest economy, Brazil. The real yield on 10-year government bonds has been on a roller coaster since 2015 (Chart III). In that year, a lethal combination of corruption scandals and calamitous economic policies doomed the administration of President Rousseff, who had to step down in May 2016 amid an impeachment process. Vice President Temer took over and implemented sweeping stabilization reforms centred on budget consolidation, notably the imposition of a cap on federal spending. Following that, Bolsonaro won the presidential election in 2018 and his ruling coalition in the Congress passed a comprehensive pension reform in late 2019. Because of a sharp decline in fiscal risk, Brazilian long-term real interest rates fell by 330 bps in four years, from nearly 7% to 3.6%.

Curiously, the foreign adverse shock that was the pandemic had little effect on Brazil’s long-term rates. The emergency easing that brought the policy rate down in 2020 was a transitory step and indeed the central bank was already tightening monetary policy in the first quarter of 2021, as the economy recovered faster than expected from the pandemic crisis and upward inflation pressures resurfaced. The real yield on 10-year government bonds began to escalate when markets realized that the administration would no longer promote a reform agenda (the ruling coalition shelved the bills that would overhaul the country’s convoluted tax system) and resorted to budgetary gimmickry to spend more during the election cycle. Lula became president again in 2022 but the controversial track record of his party concerning public finances inflated risk premiums to such a magnitude that not even the passing of a tax reform and the enactment of a new fiscal framework in 2023 could dispel fears.

On the contrary, the recognition by the government that the new fiscal framework will not succeed in generating a primary surplus to help pay down debt until 2026 signified much larger public sector borrowing requirements (Chart IV) and higher indebtedness. Correspondingly, the average long-term real interest rate is now at levels last seen in 2017, following nearly a U-curve. To be sure, it smells like a structural break, with domestic factors playing a prominent role compared to events taking place in America and Europe. As for its major consequences, the Brazilian central bank interrupted the cycle of monetary easing in its policy meeting of June 19th, citing “unanchored expectations” (a typical collateral effect of budgetary instability), investment spending is trending lower and the exchange rate, which was already undervalued according to purchasing power parity estimates, depreciated a further 9% against the U.S. dollar year-to-date.

But then fiscal instability is neither curse nor destiny; indeed, it results from bad government. However, it is always possible to correct strategies. In the Brazilian case, the fiscal framework itself provides the mechanism to restore budget credibility: slower public spending. Ultimately, it is a tough political decision that challenges the tenets of populism. Will Lula rise to the occasion?

1 For a comprehensive review of this topic, see Rossi, B. (2021). “Forecasting in the presence of instabilities: How do we know whether models predict well and how to improve them”. Economics Working Paper Series #1711, Universitat Pompeu Fabra, July.

2 Kliesen, K. L. (2024)., “Has the U.S. Economy Transitioned to a Higher Long-Run Real Interest Rate Regime?” The Federal Reserve Bank of St. Louis, dated 07-Mar.

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