When it comes to investing, one factor that often gets overlooked but is critically important is the real interest rate. Defined as the nominal interest rate adjusted for inflation, the real interest rate is a key indicator for understanding the cost of capital.
The real interest rate offers insight into the true return on investments after factoring in inflation. It is calculated by subtracting the inflation rate from the nominal interest rate. For example, in 2019, the average benchmark interest rate set by the Bangko Sentral ng Pilipinas (BSP) was 4.4 percent, while inflation averaged 2.4 percent.
If we subtract inflation from the benchmark rate, this will give us a real interest rate of 2 percent. This means that if an investor earns a 4.4 percent return on a bond in 2019, with inflation at 2.4 percent, the real return after accounting for rising prices would be 2 percent.
In 2020, when the global COVID-19 pandemic upended everything, the BSP slashed nominal interest rates to 2.25 percent to inject liquidity into the market, while inflation stayed at 2.4 percent. This resulted in a real interest rate of -0.15 percent—the first time in years that real rates had turned negative.
This shift from a positive real interest rate in 2019 to a negative one in 2020 helped fuel a stock market rally, with the PSE Index surging by over 60 percent, rising from a low of 4,500 to finish the year at 7,200.
A negative real interest rate is effectively a boon for the stock market because returns on safer investments like bonds or savings accounts become less attractive, which yields negative real returns after inflation. This encourages investors to shift their capital into riskier assets like stocks, which generally offer higher potential returns.
In 2021, average inflation started to climb to 3.9 percent, while the BSP lowered the nominal interest rate even further to 2 percent. This resulted in a deeper negative real interest rate of -1.9 percent.
Despite the sharp decline in corporate earnings and uncertainty surrounding growth due to pandemic-related lockdowns, the stock market managed to stay afloat. The excess liquidity brought about by the negative real interest rate helped offset these challenges, which kept the PSE Index relatively stable.
But in 2022, when the economy reopened, inflation surged to an average of 5.8 percent, largely driven by global supply chain disruptions and rising energy costs. The BSP, responding to the inflation threat, hiked nominal interest rates to 5.5 percent, which lowered the negative real interest rate to -0.3 percent. This aggressive rate increase led the PSE index to drop by as much as 24 percent that year.
By 2023, the BSP had fully embraced aggressive rate hikes, which raised interest rate further to 6.5 percent, while inflation had receded to 3.9 percent by year-end. This resulted in a real interest rate of 2.6 percent, the first time in five years that the real interest rate had been in positive territory.
But as real interest rates turned positive, the PSE Index lost as much as 17 percent because higher real interest rates mean bonds and other fixed-income investments become more attractive relative to stocks. Higher real yields offer better returns after adjusting for inflation, which encourages investors to shift their money from riskier assets like stocks to safer assets such as bonds.
This year, inflation has begun to fall to 3.3 percent last month, which prompted the BSP to lower the benchmark interest rate to 6.25 percent. This anticipated rate cut has spurred investor optimism, which has led the PSE Index to rally and gain 21 percent so far. However, if we compute the real interest rate today, we find that it has actually risen further to 2.95 percent. This could pose challenges for the stock market to sustain its uptrend.
If inflation continues to decline without a corresponding decrease in interest rates, the real interest rate could climb further. While lower inflation might seem like good news for the stock market, the reality is that without sufficient rate cuts, a higher real interest rate could lead to an overvalued market.
How low can the interest rate fall? If we use the average real interest rate of 2.3 percent over the past twelve months as a base, and factor in the expected inflation rate of 3.6 percent for this year, we can estimate the fair benchmark interest rate to be around 6 percent.
At the other end of the spectrum, cutting interest rates too quickly to lower the real interest rate carries its own set of risks. The most obvious danger is inflation. By slashing rates, the BSP could reignite inflationary pressures.
While negative real interest rates can boost market performance by driving liquidity into equities, the opposite is true when real rates turn positive, as seen in recent years.
The BSP now faces the challenge of striking a balance. Lowering interest rates too aggressively could risk fueling inflation once again, while not adjusting rates enough could lead to higher real interest rates, increasing the chances of stock market downturns.