Why it’s time to start gazing at the “R-Star”, the only interest rate that matters

• The r-star, or the natural rate of interest, is the “price of money”, the sweet spot that keeps our savings, investments, and inflation in harmony.

• That natural rate has been falling for the past two decades, but it’s now likely to go up and stay up for much longer.

• With that being the case, you may want to avoid unprofitable growth stocks, go light on corporate bonds, and consider adding some infrastructure shares, eco-friendly assets, defense bigwigs, commodities, and a sprinkle of bitcoin to your portfolio. And make sure you’re holding some cash.

After decades of falling interest rates, investors are waking up to a new reality: money is going to stay expensive for a good long while – and not just because it’s been tougher than expected for the Federal Reserve to wrestle down inflation. See, there’s another interest rate at play here, and it’s not as easy to pin down or tweak. It’s also the reason why you might expect rates to remain higher for longer, and adjust your portfolio accordingly...

So what’s this other rate of interest?

It’s called the natural rate of interest, or the neutral rate of interest. It’s also referred to as the equilibrium rate of interest, or the r-star. Why economists couldn’t just settle on one name here is a mystery. But, whatever you call it, it’s the sweet spot that keeps our savings, investments, and inflation in harmony. Essentially, it’s the “price of money”. And like every price, it’s influenced by supply and demand: when folks save more of their hard-earned cash, there’s a lot of money up for grabs, so its “price” drops. But when governments are building roads or companies are investing in the latest tech, everyone wants a piece of the money pie, pushing its “price” up.The thing is, the neutral interest rate is the Loch Ness Monster of economics: it’s talked about a lot, but no one’s actually seen it. It’s influenced by a cocktail of economic factors, and it’s always on the move. The best we can do is try to estimate it using complex models that take into account various factors like growth, inflation, and how much we’re saving or investing.Despite its elusive nature, this rate is a “north star” for central bankers, guiding them on when they should tweak interest rates, and by how much, to keep the financial ship sailing smoothly. If the Federal Reserve (the Fed) makes borrowing too cheap in relation to the neutral rate, you get an investment frenzy with not enough saving, and a sizzling economy with hot inflation. On the flip side, if it makes borrowing too pricey, you get a savings frenzy with too little investing, and a chilled economy with rising joblessness.And investors would do well to keep the r-star in their eyes: by hinting at future interest rate moves, economic health, and inflation trends, the natural interest rate can also help them better anticipate big trends and position their portfolios accordingly.

So what’s the r-star telling us now?

Using its own model, Bloomberg crunched the numbers and found that the natural interest rate for ten-year US Treasuries took a dive from 5% in 1980 to just under 2% over the past decade. The big plunge can be explained by weak economic growth (so, less money sloshing around), shifting demographics (higher savings from baby boomers), rising inequality (more savings from the well-off), China using export money to buy heavy amounts of US Treasuries (reducing supply in the US), and slower investment by companies as technology made their operations more efficient (so less demand for money).The impact was significant: attractive mortgage rates sparked a boom in house prices, low financing overhead allowed even unprofitable firms to expand, and cheap lending costs led governments to borrow ever-bigger amounts to fund projects.But we may be at a turning point: baby boomers are clocking out and dipping into their savings stashes, thinning out the money pool. Drama with the US is suppressing China’s appetite for US Treasuries. Meanwhile, governments are rolling up their sleeves for mega infrastructure moves, which will boost demand for money. So is tackling global warming, which will likely require some hefty investments. Plus, with AI and tech wonders on the rise, the US might just hit the fast lane in growth, making dollars even more in demand.All those factors are likely to push the neutral rate of interest much higher – and to keep higher for longer. According to Bloomberg Economics, those factors are likely to lift the natural rate to 4%, which translates to a nominal ten-year bond yield in the region of 6%. And they’re likely to stay at their peak well into this decade and next, and generally remain high until 2050.

The natural rate of interest (adjusted for inflation) is likely to keep climbing, and to remain higher for much longer. Source: Bloomberg Economics.

What does this mean for your portfolio?

The pendulum swing on natural rates (that is, from low and falling to high and rising) could rattle the US economy and its markets. It’s a lot to get used to, after all. For example, climbing mortgage rates could slam the door on our beloved house price gains, dimming the warm and fuzzy wealth glow that homeowners have been basking in. And higher rates might just rain on the parade for bond and stock valuations too, as they shrink the present value of future cash flows. What’s more, many of the unprofitable companies that were given a lifeline by ultra-low borrowing costs may well disappear – potentially painfully. Even Uncle Sam’s wallet could feel the pinch with the soaring costs of servicing the country’s considerable debt. And with the financial system still finding its footing with these sky-high debt levels, there could be other unexpected plot twists along the way.

Now, it isn’t necessarily all doom and gloom: a productivity-driven surge in growth or big fiscal stimulus could boost companies’ revenues, offsetting some of the negative impacts here. If the economy can handle it – and those projections assume it will – stocks may do just fine. As for bond investors, juicy coupons might mean they can still earn good returns, even if prices don’t benefit from falling interest rates. But it’s still worth staying on your toes: higher rates will likely lead to a wilder financial roller coaster and, as we saw last year, you can’t always rely on bonds to offset your stock losses, since both asset classes can move in tandem.

So you’ll want to be prepared for whatever the r-star throws at you. And that may mean keeping stocks as your trusty sidekick but leaning into solid, profit-making companies that maximize return on capital and do more than just live off cheap loans. Thermo Fisher, Danaher, and Accenture are good examples of companies that are consistently profitable and boast a high return on capital.

Generally, reliable value stocks with steady cash flows are likely to fare better than speculative, unprofitable growth ones in this environment. But it doesn’t mean you should avoid any not-so-cheap growth stocks: US tech giants like Microsoft, Apple, and Alphabet may not be cheap cheap, but they’re efficient, profitable, and well-managed. Stocks that have strong compounding power and the ability to handle high interest rates are also worth a look.

Infrastructure plays, eco-friendly assets, and defense bigwigs might also be poised to shine with more government spending in the mix. And you may want to keep an eye on commodities too – they’re pretty chill about rising interest and might even get a boost from those giant spending plans and from whatever money gets pulled out of risky bets.

Consider sprinkling in a dash of bitcoin as well if that’s your thing – because in investing, it’s always good to expect the unexpected. Oh, and cash doesn’t look too bad right now, so you might want to keep some on the side to deploy when opportunities present themselves – because they probably will.