Interest rates

A trillion dollar bet that interest rates won’t go up far

A build-up of bets on rising interest rates did nothing to derail a stock rally based on the belief that policy tightening by the US Federal Reserve and other central banks won’t go so far than previously.

A new wave of COVID-related uncertainty has seen markets retreat slightly from sharp rate hikes predicted next year by the Fed, Bank of England and others. But the most recent comments from Fed boss Jerome Powell indicate he’s on track to hike rates several times over the next two years.

Stock markets have been mostly unfazed by the talk of the rate hike – equity funds have posted entries every week this year except for two. In a world where bonds, on an inflation-adjusted basis, yield well below 0%, there is simply no alternative, investors say.

And these negative “real” returns, along with stubbornly low longer-term government borrowing costs, flattening yield curves and soaring stocks, all rely on the idea that terminal rates – or wherever. central bank policy rates will peak – will be lower than in previous cycles. .

The previous cycle of Fed rate hikes peaked at 2.25% -2.5% in 2018. But the coming cycle will end below 2%, according to the euro forward rate view. dollar on US rates in five years, an approximation of the EDZ26 terminal rate.

This bet, which is lower than the 2.5% projected by the Fed itself, reflects the belief that the policy tightening could end before interest rates reach the 2% inflation target of the Fed. This implies that “real” US interest rates will remain negative.

It is a similar picture in the euro area and in Great Britain, where terminal rates are respectively slightly above 0% and slightly below 1%.

“What the stock markets are saying (is)… interest rates will not be very high and real yields will remain low,” said Craig Inches, head of rates and liquidity at Royal London Asset Management.

“The bond markets are saying… we’ll keep long-term yields low because we think (rates) will rise and then fall straight back.”

But there is no margin for error.

A trillion dollars has been poured into global stocks this year – more than the previous 19 years combined – taking stock valuations to new highs. Risk premiums on corporate bonds are historically low, while the cumulative debt of households, businesses and sovereigns soared by $ 36 trillion during the pandemic.

For this reason, many believe that real US yields – currently at minus 1% on the 10-year benchmark – will need to stay below zero for years, if not decades. And yields remain stubbornly low on long-term bonds – 10-year Treasuries have peaked just below 1.8% this year.

“What has motivated the longest part of the curve is the expectation that once central banks start to raise rates, they will not be able to come any closer to the levels they reached during the previous bull cycles, ”said Barnaby Martin, head of credit strategy at BofA. .

TIGHTROPE

The natural or neutral rate, sometimes called r-star, is essential for estimating the final rate, the equilibrium level of rates where full employment coexists with stable inflation.

This rate is steadily declining in the developed world. The reasons range from an aging population to high savings rates and the United States is no exception, with the inflation-adjusted r * falling to around 0.4% last year from 2.5% in 2007.

The risk is that neutral rates turn out to be higher than the markets expect.

Long-term bond yields, stifled by huge demand for safe securities, are a misleading indicator, some argue.

Second, early and aggressive rate hikes built in against the Fed’s own projections suggest investors are not buying the Fed’s move to a flexible average inflation target (DONE). With DONE, the Fed is targeting average inflation of 2% over time and will tolerate temporary overruns.

Guneet Dhingra, head of US rate strategy at Morgan Stanley, noted that the Fed intended to raise the neutral rate when it launched its new inflation strategy.

“As long as you can call the framework FACT successful, you can also say that the Fed was successful in raising the neutral rate higher than the last cycle,” Dhingra said, predicting that the final rate could end above. 2.5%.

Rates could also be raised by increased business spending, better productivity and most importantly, changes in the labor market. Here, economists will be watching the NAIRU rate – the lowest unemployment rate can go without increasing inflation.

The question is whether the pandemic will reverse a fall in the NAIRU that has lasted for years, if, for example, workers gain more wage bargaining power.

There is no sign of a wage spiral yet, although current labor shortages mean betting on market terminal rates could face challenges.

And if the shortages ease, it could increase the likelihood that the Fed will stick to the rate hike cycle it is currently forecasting.

A “violent” revaluation of long bonds is a risk, explains Ludovic Colin, portfolio manager at Vontobel Asset Management.

“For stocks to maintain the current valuation they have, it will be a very tight rope they walk on.”
Source: Reuters (Report by Yoruk Bahceli Additional Report by Sujata Rao Edited by Sujata Rao and Mark Potter)