Low interest rates but high inflation

Chart of the week 

The chart shows the real interest rates in the US and Europe and their development since the beginning of the year. Most investors only look at nominal interest rates (the interest paid out directly on a bond) and forget about inflation. The real yield is the nominal yield minus inflation. This is negative for investors in US and EU government bonds as the chart shows.

‍

Why is this important?

‍An investor who invests in US or EU government bonds loses purchasing power. In order to maintain purchasing power, the yield of the bonds would have to be above inflation, i.e. currently above 4-5%. Government bonds or corporate bonds of first-class companies are currently not a good investment and lead to a loss of purchasing power. In order to achieve a current return of 4-5%, and thus more than inflation, there is no way around an investment in equities.

‍

Interest rate development and EUR/USD exchange rate

The level of interest rates in a country has a direct influence on the exchange rates. If, as is currently the case, interest rates in the U.S. are higher than in the EU, this leads to more money flowing from Europe to the U.S.

The central banks are independent and their decisions on the level of key interest rates have a high influence on the markets. Therefore, no stone is left unturned in forecasting their decisions. A much respected method is the calculation of the Taylor interest rate. It is based on real interest rates, expected inflation, economic output and unemployment.

The chart shows the U.S. key interest rate (blue line) and two calculation methods for the Taylor interest rate (red and orange line). It is clearly evident that the forecasts were mostly very good and rarely deviated from reality for long.

The current figures clearly show that the current key interest rate is too low and should actually have been raised some time ago. We will have to prepare ourselves for higher key interest rates in the USA. The question is not if, but when they will come.

In the U.S., it is not the head of the Federal Reserve, Jerome Powell, who decides on the level of the key interest rate, but a committee of district central bank heads. The decision is made in a vote.

The chart shows the expectation of the individual members of the panel which key interest rate they consider correct for 2022 and 2023. For 2021, all 18 panel members agreed to leave rates as they are, but for 2023, even two members see rates at 1.75%. Since the central bank rarely announces increases of more than 0.25% at once, this corresponds to at least 6 interest rate increases until the end of 2023.

It will probably not come so badly, but it is clearly evident that a majority in the panel for an interest rate increase is approaching.

It is therefore to expect for the next 1-2 years with higher interest rates in the U.S., compared to Europe.

The graph shows the purchasing power parity between USD and the EUR since the year 2000. Purchasing power parity is a term used in macroeconomics. Purchasing power parity between two countries exists when goods and services of a basket of goods can be purchased for equal amounts of money.

It is possible that for a long time there is an imbalance, but in the long term the rates tend to purchasing power parity. In the current case, this means that a weak USD and a stronger EUR can be expected again in the next 2-5 years.

Apart from the relative consideration of interest rates in the USA and in Europe, interest rates in both economic areas are more likely to rise than to fall. This argues in favor of investing in equities and against bonds. Corrections on the stock market of 5-10% should therefore be used for additional purchases.

‍

‍Elections in Germany‍

So far, the elections in Germany have not been a major topic on the stock market. This is because with 90% probability, the outcome of the elections on the stock market will be small. With a probability of 10%, however, it can have a very negative impact on the stock market.

For the stock market, of the election programs only the economic program and tax policy is important.

The chart shows the promises made by the parties in Germany in the election campaign, which tax rates they want to introduce for which level of income.

The SPD and the Greens want to raise taxes sharply for the middle class and higher incomes. For the richest of the population the tax rates are to rise even from 48% to 75%. Especially for small and medium-sized companies, the effects would be massive. A handover of the company to a new generation would hardly be possible and could lead to the dissolution of the company. Should the parties with such tax plans win the majority in the elections, this would hit the stock market very hard. 

The election forecasts are currently as follows:

The figures indicate that no coalition of two parties can obtain an absolute majority and thus form a stable government. A coalition of three parties will therefore be necessary. Thus, compromises will have to be made on the tax issue, as inevitably one of the parties (CDU/CSU or FDP) will be involved in a coalition that wants to keep taxes stable or even lower them. As long as the election forecasts remain like this, the elections should not have a big impact on the stock markets.