The gap between what an investment earns and what inflation costs is one of the oldest and most powerful signals in finance. In his latest Asset Allocation Bi-Weekly1, Patrick Fearon-Hernandez, CFA, of Confluence Investment Management argues that this signal is now flashing in ways that carry meaningful consequences for the economy, financial markets, and the pace of the Federal Reserve's next move. The message from real interest rates, he contends, is not ambiguous: the fight against inflation is far from finished.
The Real Rate, Defined
Fearon-Hernandez opens with a foundational principle. The real rate of return strips away the distortion of inflation to reveal what an investor is actually earning in purchasing-power terms. As he explains, "the real rate is calculated by subtracting the rate of consumer price inflation from the nominal interest rate, bond yield, or price gain and dividends on a stock." The implications cut in both directions: nominal gains that trail inflation represent a real loss, while returns that exceed inflation compound genuine wealth. From this premise, real rates become not merely an academic concept but a practical gauge of monetary policy stance and investment demand.
Short Rates: Still Not High Enough
The report's first major analytical focus is the federal funds rate, measured in real terms against its 20-year average of -0.8%. Using that benchmark, Fearon-Hernandez observes that the Fed's post-pandemic tightening cycle brought the real policy rate to its highest level since the Great Financial Crisis. And yet, the inflation target remained out of reach. "Following the pandemic," he notes, "Fed policymakers were never able to get inflation back down to their target despite keeping real rates high for an extended period."
That persistence of inflation, paired with a premature drift toward neutral in early 2026, set the stage for what came next. Real rates had fallen back toward neutral when markets began anticipating the Fed's hand would be forced. It was. The central bank resumed hiking in mid-September. Fearon-Hernandez is direct about what the charts now show: "the real fed funds rate is now rising again as the policymakers renew their commitment to lower inflation." His conclusion carries weight: "Based on past inflation-righting episodes, we think it remains too low. Absent political pressure to keep rates low, we would therefore expect even more rate hikes."
That last clause is notable. The qualifier about political pressure is not decorative. It introduces a genuine uncertainty that could distort the rate path, and Fearon-Hernandez lets it stand without resolution.
Long Rates: The More Dangerous Variable
The report's second chart shifts attention to the 10-year Treasury yield, both nominal and real, against a 20-year average of 0.4%. Long yields matter more broadly than short ones because they set the benchmark for mortgages, corporate borrowing, and equity valuations. The pattern in the chart diverges instructively from the short-rate story. Real 10-year yields during the post-pandemic inflation fight, Fearon-Hernandez observes, "weren't nearly as out of whack as the real fed funds rate" and "never went as far above 2.0% as they did before the GFC, which probably helps explain why economic growth remained too strong to bring down inflation."
This is a subtle but important analytical point. The failure to cool demand was partly a function of long rates that never became genuinely restrictive. Now, after drifting back toward their long-run average earlier in 2026, real 10-year yields are climbing again. The forces driving them higher include "fears of future energy prices, strong debt issuance by artificial intelligence firms, and worries about rising federal budget deficits and debt." At the level of roughly 2.0%, Fearon-Hernandez draws a line in the sand: "we suspect they could begin to weigh on economic activity and meaningfully slow the AI investment frenzy."
The AI angle is worth pausing on. Capital-intensive buildouts by artificial intelligence companies have become a significant source of Treasury supply, and if real yields cross the 2.0% threshold, the cost of that financing rises in a way that may begin to restrain the pace of investment.
Five Key Takeaways for Advisors and Investors
- The Fed is not done. Despite months of restrictive policy, inflation has not returned to target. Further rate hikes remain the base expectation at Confluence, absent political interference.
- Real rates are the right lens. Nominal yields can be misleading when inflation is elevated. Advisors should frame the rate environment for clients in real, purchasing-power terms to convey true monetary policy restrictiveness.
- Long rates pose a fresh risk. Real 10-year Treasury yields are rebounding and could soon cross the 2.0% threshold that historically weighs on economic activity. Fixed income positioning warrants close attention.
- The AI investment cycle has a cost-of-capital vulnerability. Heavy Treasury issuance by AI firms is itself a contributor to rising real yields. If that threshold is breached, a significant feedback loop for technology sector capital expenditure could be triggered.
- Structural deficits compound the problem. Federal budget deficits and rising debt levels create persistent upward pressure on real yields, independent of monetary policy. This is a long-duration risk to portfolio construction, not a short-term fluctuation.
Footnote:
Fearon-Hernandez, Patrick. "What 'Real' Interest Rates Are Telling Us." Asset Allocation Bi-Weekly, Confluence Investment Management, 5 Oct. 2026, https://www.confluenceinvestment.com/asset-allocation-bi-weekly-oct-5-2026/.
