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Podcasts from Confluence Investment Management LLC, featuring the periodic Confluence of Ideas series, two bi-weekly series: the Asset Allocation Bi-Weekly and the Bi-Weekly Geopolitical Report (new episodes posted on alternating Mondays), and a new monthly Q&A format called the Confluence Mailbag.
Welcome to the Confluence Investment Management asset allocation biweekly report for 10/05/2026. I'm Phil Adler. Bond yields are a major focus for investors these days, but yields alone only tell part of the story. Confluence chief market strategist Patrick Fearon Hernandez joins us today to share what real interest rates are telling us about the current state of the economy and how they figure into investment strategy. Patrick, the way I understand it, the real interest rate of an investment product subtracts consumer price inflation from what's known as the nominal or stated yield of that investment.
Phil Adler:So if the yield for a ten year treasury bill is 5% and inflation during the first year of an investment in that product is 3%, then the real interest rate is 2%. In other words, my investment is still profitable, but not nearly as profitable as the yield alone implies. I know my example is simplistic. What might I be leaving out?
Patrick Fearon-Hernandez:Well, actually, Phil, that's a very good description of the concept. The key point is that real returns measure changes in purchasing power, not just changes in dollar wealth. An investor might earn a positive nominal return, but if inflation is higher than that return, the investor is actually becoming poorer in real terms. Where your example becomes more sophisticated is that investors care about expected inflation, not just inflation that has already occurred. Financial markets are constantly trying to estimate future inflation, and those expectations influence everything from Treasury yields to mortgage rates to stock valuations.
Patrick Fearon-Hernandez:Another complication is taxes. If you earn a 5% nominal return and pay taxes on that return, your after tax real return may be considerably lower than the simple 2% calculation. That's especially important during periods of elevated inflation. The broader economic significance is that businesses also make decisions based on real rates. If inflation adjusted borrowing costs are low, companies are more inclined to invest in new factories, equipment, technology, and research.
Patrick Fearon-Hernandez:If real borrowing costs are high, many projects become uneconomic. That's why real rates are among the most important variables influencing economic growth and financial markets.
Phil Adler:Patrick, in your report this week, you apply the real interest rate calculation to the Fed's short term interest rate over the past twenty years. What did you find?
Patrick Fearon-Hernandez:Well, the most striking finding is that the Fed's inflation fight after the pandemic drove the real Fed funds rate to its highest levels since the global financial crisis. By our calculations, policymakers created a significantly restrictive monetary environment by keeping nominal rates high while inflation gradually declined. Historically, the average real Fed funds rate over the last twenty years has been about a negative 0.8%. In other words, mild accommodation has actually been the norm. When the real policy rate moves substantially above that average, monetary policy generally becomes restrictive.
Patrick Fearon-Hernandez:What's particularly interesting is that inflation never fully returned to the Fed's 2% objective despite years of unusually high real short term rates. That tells us inflation pressures proved more persistent than many economists initially expected.
Phil Adler:So, again, we can assume that Fed policy is restrictive when real Fed short term interest rates are higher than average.
Patrick Fearon-Hernandez:I would call that a reasonable rule of thumb. Economists often compare real rates against estimates of the so called real neutral rate, the level that neither stimulates nor restrains economic activity. When the real Fed funds rate is meaningfully above that neutral level, policy is generally restrictive. When it's below neutral, policy is accommodative. Of course, we should avoid treating this as an exact science.
Patrick Fearon-Hernandez:The neutral rate can't really be calculated with accuracy. And even if it could, one would expect it to fluctuate over time as demographics, productivity growth, government borrowing, and global savings patterns all evolve. Nevertheless, comparing current real rates against longer term averages provides a useful framework. The simple message is that higher real rates increase the cost of capital, discourage borrowing, and tend to slow economic activity.
Phil Adler:Patrick, what are real interest rates showing us lately?
Patrick Fearon-Hernandez:Well, in our view, they're suggesting the monetary conditions are becoming restrictive once again. Earlier this year, real short term rates drifted toward what we would consider a neutral position. Investors increasingly questioned whether policy was sufficiently tight to finish the job of bringing inflation down. That concern intensified as energy prices rose and inflation remained above target. The Fed responded with a 25 basis point increase in interest rates in September, raising the target Fed funds rate to 3.75 to 4%.
Patrick Fearon-Hernandez:As a result, real short term rates have begun rising again. Markets appear to be receiving a clear signal that the central bank remains focused on price stability now.
Phil Adler:And what does this suggest about whether the Fed will keep raising the benchmark rate?
Patrick Fearon-Hernandez:Our interpretation is that additional tightening remains a distinct possibility. In our report, we argue that real rates may still not be high enough to decisively return inflation to target. Looking at previous inflation fighting episodes, successful disinflation campaigns often required policy to remain restrictive for longer than many market participants expected. Recent Fed communications have also remained relatively hawkish. Policymakers continue to emphasize that inflation has stayed above target for an extended period and that they're committed to restoring price stability.
Patrick Fearon-Hernandez:That doesn't guarantee more rate hikes, but it suggests investors should not assume the tightening cycle is complete.
Phil Adler:Patrick, let's return to bond yields now and and how they are affected by the real interest rate calculation and what this tells us about the economy. The ten year treasury note, of course, is the basis for a host of interest rate calculations that have a major impact on consumers. First, a little bit of recent history. How did real ten year yields perform coming out of the pandemic?
Patrick Fearon-Hernandez:Well, interestingly, real ten year treasury yields behaved differently from short term rates. They certainly increased during the inflation fight, but they never reached the extraordinarily restrictive levels seen before the global financial crisis. In our analysis, real ten year yields remained relatively contained compared with real Fed funds rates. That distinction is important because long term yields influence mortgage rates, business borrowing costs, commercial real estate financing, and the discount rates that investors use when valuing stocks. In many ways, long term financial conditions stayed easier than policymakers probably would have preferred.
Phil Adler:So this helps explain why economic growth remained strong during this time period.
Patrick Fearon-Hernandez:Exactly. If long term real yields had risen much more aggressively, we probably would have seen a greater slowdown in housing, in capital spending, and in equity valuations. Instead, businesses continued investing aggressively, especially in artificial intelligence infrastructure. Consumers also remained relatively resilient despite higher borrowing costs. The economy repeatedly demonstrated more strength than many forecasters expected, and that resilience helps explain why inflation remained stubbornly above target.
Phil Adler:Well, bring us up today. How are real ten year yields performing lately?
Patrick Fearon-Hernandez:Well, they've been moving higher quite rapidly. Our report noted that real ten year yields had fallen back toward their long term average earlier this year, but have since rebounded sharply. Outside data sources tell a similar story. Measures of ten year real treasury yields recently moved above 2%, and by some calculations, approached 2.5% to nearly 3%. Those are meaningful moves because real yields influence virtually every major asset class.
Phil Adler:Do you expect this will continue?
Patrick Fearon-Hernandez:Well, we think the risks point in that direction. Yes. Our report identifies several forces that could push real yields even higher. First, investors remain concerned about future energy prices. Second, there's been extraordinary financing demand around firms building AI related infrastructure.
Patrick Fearon-Hernandez:And third, federal budget deficits continue to require substantial government borrowing. All three factors increase demand for capital or increase the supply of debt securities, basic economics suggest that can place upward pressure on real interest rates. The result may be an environment where real long term borrowing costs remain elevated for an extended period.
Phil Adler:Patrick, when is a likely turning point when the real ten year yield begins to slow economic growth?
Patrick Fearon-Hernandez:In the report, I suggested that a real ten year yield above roughly 2% for an extended period could begin creating meaningful economic headwinds. We're already near that territory. In fact, recent measures show real yields exceeding 2% and in some cases moving considerably higher. The first place we'd likely see the impact of this is in rate sensitive sectors. Housing affordability could worsen.
Patrick Fearon-Hernandez:Corporate borrowing could become less attractive. Highly valued growth stocks could face valuation pressure because investors discount future earnings at a higher rate. More importantly, higher real yields could begin slowing the pace of AI related capital spending, which has been one of the economy's strongest drivers.
Phil Adler:Well, as of late September, I think we can describe the stock market's performance as resilient in the face of economic and geopolitical concerns. If there is a brief message that real interest rates are currently sending to stock investors, what is that message?
Patrick Fearon-Hernandez:Well, the message is simple. Don't ignore the competition. For years, investors had little alternative to equities because real bond yields were extremely low or even negative. Today, investors can earn meaningful inflation adjusted returns in fixed income. That changes the valuation framework for stocks.
Patrick Fearon-Hernandez:When real Treasury yields rise, the hurdle rate for owning equities also rises. Companies need stronger earnings growth to justify high valuations. This doesn't mean stocks must fall. It means investors should become more selective and more attentive to valuation and profitability.
Phil Adler:One more question for today, Patrick. Sometimes it seems like oil prices are driving everything. Could this all turn on a dime if the Iran war ends and oil prices drop?
Patrick Fearon-Hernandez:An end to the conflict would certainly matter. Lower oil prices would likely reduce headline inflation pressures, improve consumer purchasing power, and lessen some of the urgency behind further Fed tightening. That's the bullish scenario many investors hope for. However, I would caution against viewing energy as the only factor at work. The economy is also being influenced by strong private sector investment, substantial government borrowing, structural labor market dynamics, and ongoing demand for AI infrastructure.
Patrick Fearon-Hernandez:Therefore, even if oil prices decline meaningfully, real interest rates could remain elevated. The inflation outlook might improve, but the forces supporting higher real yields would not necessarily disappear. In other words, lower oil prices could ease the pressure, but they probably won't solve the entire puzzle.
Phil Adler:Thank you, Patrick. The title of this week's report is what real interest rates are telling us, and you can find a link to the written report dated 10/05/2026 on the Confluence webpage, confluenceinvestment.com. Our discussion today is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice, and this information does not constitute a solicitation or an offer to buy or sell any security. Our audio engineer is Dane Stole.
Phil Adler:I'm Phil Adler.