Why US interest rates must rise

 

Chief Economist, Matthew Peter

Despite tighter monetary policy by the US Federal Reserve (Fed), above trend US economic growth and an unemployment rate at multi-decade lows, the 10-year US bond yield languishes at the same level it was at six years ago. Have we entered a new regime that will see US sovereign bond (Treasuries) yields stuck below 3% indefinitely, with its dire implications for fixed income investors? Our view is that while US Treasury yields will not rise to their pre-GFC levels, we do think that yields will climb higher over coming months and will most likely establish a level a little above 3% over 2019. As US Treasury yields climb, we expect global yields to rise as central banks in Canada, Europe, UK, Australia and eventually Japan gradually tighten policy over 2018 and 2019.

We expect upward pressure on US Treasury yields to come from three main sources: (i) ongoing rise in US and global inflation, (ii) the sale of US bonds as the Fed reduces the size of its balance sheet, and (iii) a slowing in the global demand for US Treasuries; particularly from China. Although global growth has risen strongly over 2017, with the US, European and Japanese economies all growing at above trend rates, core inflation rates remain tepid and, importantly for longer maturity bond yields, 10-year break even inflation rates (that capture the market’s inflation expectations over a 10-year horizon) remain at low levels.

For example, the current US 10-year break even inflation rate remains below 2.0% at 1.9%, lower than the 2.2% CPI inflation rate implied by the Fed’s 2.0% target on the Personal Consumption Expenditure measure of inflation. However, we are currently seeing evidence of inflationary pressure creeping back into the US economy since the collapse in the oil prices caused US and global rates of inflation to plummet over 2014/15. US producer prices continued their steady climb since growth stalled in 2015 to grow at an annual rate of 2.4% in October. Similarly, US import prices are increasing at a 2.5% pace, having registered falls of around 10% over 2015.

Of course, one of the key drivers of underlying inflation is wage growth. The weak wage growth in face of tighter labour markets is one of the key inflation puzzles of recent years. Nonetheless, as the US unemployment rate remains below 5%, wage growth is edging higher averaging around 2.5% over recent months, up from 2.0% growth in 2015. Rising growth rates in wages, producer prices and import prices will continue to place upwards pressure on US core inflation, which will continue to grind higher over 2018/19 to be consistent with the Fed target rate. As inflation rates rise investors will re-rate their longer-term inflation expectations higher, pushing break even inflation rates and nominal bond yields higher. In the US, a re-rating of expected inflation will add around 40 bps to US 10-year Treasury yields.

Adding to the upward pressure on US Treasury yields will be an increase in the supply of Treasuries as the Fed reduces its bond portfolio over coming years. Supply side pressures will be added to by issuance of around US$1.5 trillion in bonds over the coming 10-years as the Federal government funds the GOP’s Tax Cuts and Jobs Act measures. On the other side of the bond market, we expect to see growth in foreign demand for US bonds to stall, adding to the supply-side pressure on bond yields. Our modelling of the combined effect of the Fed balance sheet reduction program and the GOP tax package is to add around 50 bps to the US 10-year sovereign bond yield, of which we estimate only around 10bps has been priced by the market.

Finally, we expect that the next few years will see subdued growth in foreign demand for US bonds; particularly from the two biggest holders of US government debt – China and Japan, who between them hold around 20% of US bonds on issuance to the public. During the Fed’s last tightening cycle, from 2004 to 2007 under the direction of Governor Greenspan, rising demand for US bonds from China and Japan was an important influence on limiting the rise in 10-year Treasury yields. Between 2004 and 2007, holdings of US Treasuries by China increased by around US$800 billion (from US$200 billion to US$1000 billion), while Japanese holdings increased from US$600 to US$1000 billion.

However, since around 2011, Chinese and Japanese holdings of US Treasuries have largely remained constant at around US$1.1 trillion. The reduction in demand for Treasuries from China and Japan reflects a shift away from export-driven growth, which generated a rising domestic rate of savings and capital outflow that was channelled in to US assets, towards growth driven by domestic demand, leading to a fall in the savings rates and a reduction in the rate of capital outflow and the rate of accumulation of US assets. In the absence of rising foreign demand for US Treasuries, we expect that rising inflation, Fed bond sales and larger government deficits will push up US 10-year Treasury yields to just over 3% over 2018/19.

Table 1: Financial market movements, 9 – 16 November 2017

Equity index

Level

Change

10-yr government bond

Yield

Change

Foreign exchange

Rate

Change

S&P 500

2,585.6

0.0%

US

2.38%

3.4 bps

US Dollar Index (DXY)

93.93

-0.5%

Nikkei 225

22,351.1

-2.3%

Japan

0.05%

2.2 bps

USD-JPY

113.06

-0.4%

FTSE 100

7,386.9

-1.3%

UK

1.31%

4.4 bps

GBP-USD

1.320

0.4%

DAX

13,047.2

-1.0%

Germany

0.38%

0.1 bps

EUR-USD

1.177

1.1%

S&P/ASX 200

5,943.5

-1.8%

Australia

2.58%

-1.5 bps

AUD-USD

0.759

-1.2%

Source: Bloomberg

 

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