Why the rise in US interest rates is capped

Editor’s note: Given events since this post was written, validating its view that rates will rise more slowly than anticipated in August, we are putting it outside the paywall.

Today’s commentary

Summary: the same people who have been screaming inflation for the past few years are now saying that interest rates are finally about to explode. This is alarmist nonsense that disregards the influence policy rates have over the term structure of rates. It also disregards real economy feedback loops. I explain here.

I have often said that the Fed exerts a dominant influence across the yield curve, not just on the short end. And by this I meant that long-term interest rates on government liabilities are really a series of future short-term rates. It tells you that the interest rates of tomorrow are essentially an amalgam of expected future policy rates that reflect inflation and real interest rates plus a term premium. In today’s world in which the central bank targets a specific policy rate over which it has absolute control, understanding how the term structure of rates comes to be is important. Knowing what the central bank intends to do will affect your view on futur rates and thus on discount rates for future cash flows for stocks, bonds and all financial assets. This can be make or break in investing.

As the Fed has started to talk about ending quantitative easing, interest rates in the US have been shooting up. Anticipation of future rate hikes go hand in hand with the removal of policy accommodation via the tapering of quantitative easing. Nevertheless, interest rates expectations have not become unanchored. Yes, the market has begun to anticipate earlier rate hikes and so the term structure of the yield curve has steepened. But, what one should note then is that it is the term premium that has been increasing the most as concerns about the Fed’s tapering.

Two months ago, Gavyn Davies had it right when he wrote the following:

In the absence of a full-blown crisis of confidence, it is hard to see how the bond yield can rise very far, provided that the Fed keeps forward short rates at virtually zero for several years to come. It is true that the term premium – ie the difference between the long term yield and the expected path for short rates – is abnormally low at present, and has started to adjust upwards (see this blog). If it went fully back to normal, it would take long yields to about 3 per cent, but an adjustment of that scale seems improbable in the extremely subdued state of the global economy at present.

The bond market vigilante paradigm is wrong. In a convertible, floating exchange rate system, rates for sovereign currency issuers don’t rise because bond market vigilantes force them up. The currency is the release valve for that. Instead, rates rise because inflation or real interest rate expectations rise or because term premia rise. What Gavyn Davies is telling us is that given the central bank’s control of policy rates, still low inflation, the Fed’s stated goal of permitting higher medium-term inflation if necessary, and the fragile state of the economy, we should not expect rates to rise all that much more. In fact, I would argue they should fall.

With the mortgage refinancing boom ending and the housing recovery not producing as much growth as anticipated, the US economy remains at stall speed. Any shock from energy prices to an unexpected fiscal drag to higher interest rates would pull the economy back down and invite more policy accommodation from the Fed. The people promoting the bond vigilante story forget that the economy, interest rates and the Fed’s reaction function are all interdependent. If rates rise enough, it will trigger a downdraft in the economy, more policy accommodation and a fall in expected future inflation and in future policy rates.

In short, there is only so far up that US interest rates can go before they induce an economic swoon that forces them down again. For now, the US is trapped in the low growth, low rate paradigm until it reaches higher unemployment and higher capacity utilization.