Interest rates, real estate, shares and gold

In addition to share prices, residential real estate prices in some countries, e.g. the USA, and most recently the price of gold have also reached new all-time highs. The reason often given for this is the announcement by the major central banks in the USA and the eurozone that they will start cutting interest rates this year. Allegedly, all forms of investment will benefit from this.

In the following, we examine whether and when this widespread assumption can be relied upon for real assets (real estate, shares, gold).

A cursory glance at chart 1 confirms the thesis. Since the 1970s, all tangible assets (real estate, shares, gold) have risen, while interest rates have fallen sharply. However, a closer look reveals that until the beginning of the 1980s, not only real assets but also interest rates had risen. Real assets always rise in the long term as long as global economic output, consisting of the number of workers and productivity per capita, increases, which has been the case since the beginning of industrialization 200 years ago and especially since 1970 (chart 2).

We therefore examine the influence of interest rates on the trend-adjusted development of real asset prices below. This shows whether real assets react particularly positively to falling interest rates.

Since the gold backing of the US dollar was abolished more than 50 years ago, the price of gold has risen by an average of 7.3% annually from USD 44 to USD 2,177, with strong fluctuations (chart 3). However, the usual narrative that high interest rates would make gold unattractive as an investment, as gold bars are not known to yield interest, does not correspond to reality. When the gold price had risen particularly sharply up to 1980, interest rates had also climbed to a high level of between 10% and 13% (chart 4, red circle). The fall in the price of gold over the following 20 years from USD 850 to USD 258 (chart 3) was accompanied by a global decline in interest rates of over 10 percentage points to 4% (see chart 1); falling interest rates therefore did not help.

By contrast, a change in the yield on inflation-linked US government bonds has actually shown a close and economically logical correlation with the gold price for 15 years up to February 2022 (charts 5 and 6). When the inverse yield on these bonds, which not only fully compensate for inflation during their term but also (usually) offer interest, falls (2007 to 2012 and 2019 to 2020), they become less attractive compared to interest-free gold. Since February 2022, however, this correlation has completely broken down. The only reasonable explanation for this is that more and more investors are losing confidence in the long-term financial stability of the US due to the start of the war in Ukraine, because the geopolitical situation that has changed since then is forcing the US government, as well as European countries, to increase military spending (see the November 2023 Capital Market Outlook, which you can find here, for more information on the problem of the current extremely high level of government debt worldwide and the future additional burdens caused by geopolitics, an ageing population and the energy transition). An inflation-protected US government bond with a current annual interest rate of almost 2% is actually more attractive than gold. In the last two years, rising interest rates - for both inflation-linked and normal government bonds - have therefore not hurt the gold price. As a result, gold only reacted to falling interest rates on inflation-linked bonds with price gains until February 2022, but not to falling interest rates on normal bonds (chart 4). Nevertheless, falling interest rates will not harm gold going forward.

In the case of real estate, too, it is not only interest rates but also inflation that influence pricing. However, it is not the simple price trend as with gold that is used, but the per capita income of the respective country, from which the purchase prices, rents and mortgage interest must be paid. Per capita income is the basic trend that residential real estate prices follow. The interesting question is therefore whether residential real estate prices rise faster than per capita income when interest rates fall, which would make perfect economic sense.

In Germany, however, for 40 years until 2011 there was an unexpected and yet quite close correlation between interest rates and house prices (relative to per capita income). The lower the interest rate, the weaker the development of relative house prices (chart 8). Chart 9 then shows the turnaround. Only with interest rates below 3% do relative house prices rise as interest rates fall (left half of chart 9), but only until 2021.

There is also a trend towards falling relative house prices with falling interest rates in the USA and Japan (charts 11 and 13), although the correlation is only quite strong in Japan and only very weak in the USA (the measure of this is the R² figure, which ranges between 0 (no correlation at all) and 1 (exact correlation)).

Only in the UK is the expected correlation between relative house prices and interest rates evident, namely rising house prices with falling interest rates, albeit a rather weak one.

Conclusion: Falling interest rates alone are no guarantee of rising prices, neither for gold nor for house prices in Germany, the USA, the UK or Japan, but prices have fallen at least as often. However, if inflation is taken into account, a more stable and economically logical picture emerges, not only for gold, but also for residential real estate.

The following two charts 16 and 17 show for Germany and the USA a close correlation between the most important cost factor of a residential real estate investment, mortgage interest rates, and the expected long-term return, namely rental yield + average inflation over the last 10 years. These two figures are used because the rental yield alone does not show a stable correlation with mortgage interest rates in either country. In addition to the current rent, real estate buyers also expect long-term rent increases. In the real estate market, these are obviously derived from the inflation experience of the last 10 years, as only the expected return made up of rental yield + average inflation of the last 10 years shows the strong correlation with mortgage interest rates shown in Figure 16. This correlation exists in the same way in the USA (R² = 0.87, chart 17), the UK (R² = 0.67) and Japan (R² = 0.85). Thus, as (mortgage) interest rates fall, earnings expectations on the residential real estate market decrease. However, whether house prices then rise depends not only on interest rates, but also on rental yields and expected rent increases, i.e. average inflation over the last 10 years.

The following scenario is the most likely for the future development of house prices in Germany. House prices in Germany are currently valued as they have been since 1970. With a mortgage interest rate of 3.5%, the expected return would be 5.48% if the red dot were exactly on the dotted line. In fact, with a rental yield of 3.11% and average inflation of 2.24%, this figure is almost identical at 5.35% - the red dot is only just below the line. If house prices and interest rates were to remain stable over the next few years, residential real estate would be increasingly undervalued, as the current sharp rise in rents for new lettings will lead to a gradual increase in rental yields due to the considerable housing shortage, especially as the rent index will also show higher permissible rents in future as a result. In addition, average inflation will continue to rise over the next few years, even if inflation remains at the current 2.5%. This will lead to a significant increase in income expectations (the red dot would move upwards). If interest rates then also fall, the German housing market would have significant upside potential.

In the US, on the other hand, the expected return on a mortgage rate of currently 6.6% should be 8% (chart 17), but the red dot is significantly lower, at just 6.4% (rental yield: 3.6%, average inflation 2.8%); the market is therefore significantly overvalued. US house prices have risen to a new historic high in the last two years (chart 10), although the mortgage rate rose sharply from 2021 (3.11%) to 2023 (6.61%). However, as in Germany, there is also a housing shortage in the US; at 0.9%, the vacancy rate is close to the historic lows since 1957 (chart 18). There is therefore no immediate threat of a crash here; before the start of the subprime real estate crisis, vacancy rates were at a record level of 2.9%.

So far, we can state for residential real estate that falling interest rates alone do not justify a forecast of rising house prices. However, in the real estate markets shown, there is a stable and economically logical connection between falling mortgage interest rates and falling earnings expectations, consisting of rental yields and average inflation over the last 10 years.

The previous analyses referred to debt-free real estate investments. It is more realistic to include debt, as most real estate buyers are likely to work with borrowed capital. In the case of indebted real estate investments, interest costs should become increasingly important. An initial analysis of German real estate portfolios with an average debt of around 50% of the value of the properties seems to confirm this assumption. Chart 19 shows the trend-adjusted price performance of 4 German listed real estate companies (Vonovia, LEG, TAG, Grand City Properties), weighted by current market value. We also show the interest rates for 10-year German government bonds. The stable opposing trend is clearly visible and is confirmed by the statistical analysis (chart 20).

With a very high R² value of almost 0.9, one could therefore confirm the thesis that falling interest rates lead to strong increases in value for indebted residential real estate investments and vice versa. Unfortunately, this picture is clearly clouded by a longer-term view of the global index of real estate stocks from the index company MSCI since 1995 (Figure 21). Until March 2009, the low point of the global stock markets and thus also of real estate shares following the collapse of Lehman Brothers, falling interest rates were not accompanied by rising share prices, but by falling share prices (Figures 21, 22).

Only then did falling interest rates have a price-supporting effect (charts 23, 25), interrupted by the deflationary coronavirus crisis (chart 24). Interest rates therefore certainly had an influence on prices, but in alternating directions.

Falling interest rates should actually always be beneficial for shares. Most companies are more or less highly indebted and therefore benefit directly from falling interest rates, as their own debts incur lower interest costs. In addition, this makes these forms of financing cheaper for the customers of companies who make their purchases with loans, installment payments or leasing; more can be purchased. Finally, falling interest rates make investments such as savings accounts or bonds less attractive than shares.

Until the end of the 1990s, this logical correlation was valid for several decades in both the USA and Europe (charts 26, 27). Then, however, a negative correlation - falling interest rates had previously meant rising share prices and vice versa - became a positive one (green field in both charts).

The trigger was a sudden uncertainty about the future stability of the financial system. In October 1998, Russia ran into payment difficulties and the yield spreads between bonds with lower credit ratings - including government bonds - and absolutely safe government bonds rose sharply. The largest hedge fund in the world at the time, with a volume of 125 billion US dollars, managed by two Nobel Prize winners in economics (Robert C. Merton and Myron S. Scholes) had bought bonds with less than 5% equity on credit, among other things, because it was assumed that the above-mentioned yield spreads would not exceed a certain level, which then occurred due to Russia's payment problems. With the active help of the US central bank (including three interest rate cuts) and numerous major international and investment banks, the fund was stabilized and wound up by 2000 (source: Wikipedia). This was the first major bailout by the US central bank in decades. The economic logic was that falling interest rates could possibly be an indication of problems in the financial system. As it was not certain whether the next crisis would be solved by a central bank again, people took a very short-term approach, fleeing equities when interest rates fell and only investing again once interest rates had stabilized. The fact that equities benefit from falling interest rates in the long term was beyond the short-term investment horizon at the time. When the US central bank announced extensive aid measures immediately after the Lehman bankruptcy in September 2008 (interest rate cuts, money printing to buy mortgage securities, supplying all US banks with fresh equity), confidence returned. People in the US were convinced that the central bank would help in any future crisis. The European Central Bank, on the other hand, made the mistake of not printing money from 2008 onwards because it was wrongly feared that there was a risk of inflation. As a result, a new crisis emerged in Europe from 2010 (Greek bankruptcy, later problems in Ireland, Portugal, Italy and Spain). Only now was the ECB under Mario Draghi prepared to print money as well. However, it was only after the ECB provided rapid and effective assistance with the outbreak of the coronavirus crisis that confidence in long-term financial market stability returned in Europe and the correlation between equities and interest rates became negative again. This also explains the behavior of international real estate stocks (REITs), which reacted positively to falling interest rates after the Lehman bankruptcy until the coronavirus crisis in 2020 (chart 23), reacted negatively during the coronavirus crisis until 2022 and have been positive again since then.

Whether interest rates will actually fall is something we cannot know any better than the central banks, which are known to want to cut interest rates from June 2024 if nothing intervenes. If you look at the inflation trend in recent years to determine the wisdom of a central bank, the Swiss central bank is clearly in the lead, as inflation in Switzerland was a maximum of 3.5% (chart 28). If this central bank has now been the first to start cutting interest rates slightly, the hope of interest rate cuts in the near future may be justified.

Conclusion:

Falling interest rates will certainly not harm the gold price, although the gold price only reacted positively to interest rate cuts in relation to the yield on inflation-linked government bonds until February 2022. Since then, it has also risen with rising yields on these bonds. At least the undervalued German residential real estate market will also be able to benefit from falling interest rates, probably more than the overvalued US residential real estate market. Falling interest rates also bring better price prospects for REITs, as well as for the normally valued European equity markets. They will at least be able to support the overpriced US equity market.

Finally, our key statements from the capital market outlook from March 2021, which you can find here can be found here:

Three years ago, we showed the enormous superiority of an international equity portfolio compared to government bonds for the purpose of funded pension provision. Since 1900, an annual return of 5.7% p.a. in real terms for equities contrasts with a comparatively paltry figure of 2.1% p.a. for government bonds, which - and this is particularly pathetic intellectually - have a higher risk of fluctuation than equities, namely 7% compared with 5%, even over periods of 10 years, which is by no means long for pension provision purposes. In addition, the considerable impact of the high cost burden of many German pension schemes on returns was shown, while Sweden, for example, achieves high returns for low-income earners with its almost free equity-heavy state fund AP7. There is absolutely no justification for the resistance to equity-based pension provision, especially from left-wing politicians in Germany.

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You can also download the capital market outlook here.