The Upset of Real Interest Rates, A Warning Letter to Asset Markets – What 2025 Charts Tell Us About the Future Investment Landscape

The Structural Rebound of Real Rates: The End of a 40-Year Decline, Start of a New Era

(Source: Financial Times)

After nearly four decades of decline, real interest rates reversed course sharply in 2021. The graph above shows real yields on 10-year inflation-indexed bonds in the U.S. (blue) and the U.K. (pink). In the U.K., where data is available since the mid-1980s, and in the U.S. since the mid-2000s, real rates declined steadily and fell below 0%, providing unprecedented liquidity to global asset markets. Since 2021 however, real rates have surged to over 2% in both countries—marking the beginning of a structural shift in the global financial environment. Let’s explore this in detail.

Inflation Expectations, Real Yields, and the Policy Dilemma

The second chart shows the "break-even" inflation expectations, calculated as the spread between nominal yields and inflation-linked bond yields for 10-year maturities in the U.S. and U.K. Inflation expectations spiked to 3~4% after the 2020 pandemic but stabilized back to 2~3% post-2023.

This means the recent rise in real yields isn't driven by rising inflation expectations, but rather by stronger nominal interest rates, central bank tightening, and higher market risk premiums. A separate chart shows that 10-year government bond yields in major economies jumped sharply after 2022.

Growth Forecasts and Asset Markets: The Risk of Low Growth and High Real Rates

The fourth chart illustrates that 2025 economic growth forecasts are being rapidly downgraded across major advanced economies. The U.S., Europe, Japan, and Germany are all projected to grow at only around 1%. If real rates remain high, we could enter a new environment of low growth and high interest rates—very different from the past.

Fiscal Debt Pressures: A New Market Equilibrium

The fifth chart shows that government debt has reached historic highs in both developed and emerging markets. Debt-to-GDP ratios in advanced economies are nearing 120%, the highest since WWII. These debt burdens limit the ability to cut interest rates and create upward rigidity in real yields.

How Rising Real Rates Impact Asset Markets

1. Equities: Structural Downward Pressure on Valuations

   With real yields rising above 2%, the discount rate applied to future cash flows increases, structurally lowering equity valuations. Growth stocks and tech firms, which depend heavily on long-term earnings expectations, are especially vulnerable. In contrast, value stocks with strong cash flow and dividends—such as those in the financial sector—may hold up better.

   
   

2. Real Estate: Higher Financing Costs, Compressed Yields

   Commercial and residential real estate, once a go-to alternative investment during the low real rate era, now faces higher financing costs and lower capitalization rates. This structural rebound in real yields could trigger price corrections and shift capital flows. Investors will need to focus more on asset and region selection, and adopt strategies centered on stable cash flows.

   
   

3. Bonds: Duration Risk and New Investment Opportunities

   A rise in real interest rates implies a price decline for existing low-yield bonds. On the other hand, newly issued bonds can offer higher interest rates, increasing their investment appeal. Investors should focus on duration management and alternative products such as inflation-protected securities.

   
   

   In a rising real interest rate environment, managing duration is important because bond prices are sensitive to interest rate changes (duration risk). Duration refers to how sensitive a bond’s price is to interest rate movements. For example, a bond with a duration of 5 years will fall approximately 5% in price if the market interest rate rises by 1 percentage point. Conversely, if interest rates fall by 1 percentage point, the bond’s price will rise by about 5%.

   
   

   When real interest rates rise (i.e., nominal rates increase without a change in inflation expectations), existing bonds with low coupon rates will decline in value. In this case, long-duration (long-maturity) bonds experience greater price drops. In contrast, short-duration (short-maturity) bonds are less sensitive to interest rate changes and exhibit smaller price fluctuations.

   
   

   Therefore, bond portfolio strategies can be summarized as:

   • If interest rates are expected to rise: shorten duration to minimize losses from rate changes.

   • If interest rates are expected to fall: extend duration to maximize price gains.

     
     

   In conclusion, during periods of rising real interest rates, newly issued bonds offer higher yields, so Investors are advised to focus on short-term bonds or inflation-linked bonds (TIPS).

   
   

4. Cash and Safe-Haven Assets

   In an environment where real interest rates have turned positive, the attractiveness of safe assets such as cash and government bonds has relatively increased. In particular, trust in the U.S. has been shaken due to various policies of President Trump. If these risks are removed, long-term demand for “safe haven” assets like U.S. Treasuries could increase.

   
   

5. Commodities & Gold: Shifting Role as Hedges

   Rising real interest rates limit the upside potential of physical assets like gold and commodities. Gold in particular has a strong negative correlation with real rates, which means its long-term momentum may weaken. However, commodity markets can still experience high volatility due to non-financial factors like geopolitical risk.

   
   

Conclusion: A New Era of Real Rates, A Turning Point for Investment Strategy

Since 2021, four key forces have converged: a structural rise in real interest rates, stabilized inflation expectations, slowing economic growth, and record-high fiscal debt. As of 2025, asset markets are entering a fundamentally different "new normal." The investment playbook of the ultra-low rate era is no longer valid. Investors must now embrace differentiated strategies across asset classes and geographies, focusing on cash flow fundamentals and sound valuations.

If elevated real rates persist, asset markets will undergo a transition period to find a new equilibrium. Investors must recognize the nature of this shift and adopt more conservative and flexible portfolio strategies.