- The 20 September Federal Reserve meeting resulted in US 10-year yields surging to their highest level since 2007 (figure 1).
- Stocks had previously factored in a resilient US economy, but not what this meant for real rates. Thus, stock prices have fallen, as well as bond prices.
- High yields are awful news for indebted corporates, home buyers, and the US budget deficit.
- The global ramifications are significant, especially for Europe and indebted emerging markets.
- Higher US rates mean weaker non-dollar currencies, including the euro and sterling.
- Unusually long lags in the monetary transmission process are behind economic resilience.
- Longer lags mean higher real rates for longer than previously thought, but not forever.
- Fed easing is therefore postponed, not cancelled. However, bond yields may rise further before they fall.
Figure 1: US Bond Yields (%)
The bond yield surge after the Fed meeting on 20 September to a 16-year high was not due to worse inflation prospects. The 10-year breakeven inflation rate between conventional and inflation-linked bonds remained in the range since July. Instead, it reflected market pricing in higher future real rates of interest. These higher expected future rates continued the trend rise in recent weeks, from a low of around 1.5 per cent in July to about 2 per cent more recently (figure 2). However, the Fed did validate market pricing, leading to capitulation by sceptics and encouraging the market to factor in more upside risk for rates.
Figure 2: US Bond Yield Decomposition (%)
The Fed raised its fed funds projection from June by half a point in 2024 and 2025, to 5.1 per cent and 3.9 per cent, respectively. Its longer-run fed funds projection remained at 2.5 per cent. This longer-run projection implies a real interest rate of only 0.5 per cent, which is low compared with the Fed’s 1.8 per cent estimated trend growth. Thus, Fed projections do not show higher real rates forever but a slower return to their modest long-run equilibrium level. The upward shift in projected fed funds in 2024 and 2025 reflects firmer than expected growth (the Fed’s 2023Q4 y/y growth forecast rose from 1 per cent to 2.1 per cent, for example). The Fed’s projections decisively do not support the “higher rates forever” analysis.
Why equilibrium real rates may have increased
The market and Fed projecting higher real rates for longer reflects the economy’s resilience despite over 500bp of Fed tightening. This resilience stems from massive federal budget deficits sustaining demand, healthy private sector balance sheets, real policy rates having only recently turned positive, and supply-side recovery in goods and labour markets.
Effects on the US economy and markets
A rise in the equilibrium real interest rate, even for a year or two, has significant ramifications for the real economy and markets. If higher equilibrium real interest rates reflected a higher equilibrium growth rate, the impact on the economy overall would be neutral, though negative for lagging sectors. The New York Fed publishes estimates of the US trend growth rate and the equilibrium interest rate (r-star or r*). The gap between the two has averaged about 0.8 percentage points in recent years (figure 3). Thus, buying the higher r* narrative implies expecting a higher trend rate of growth. Evidence for this is lacking, and the Fed projections do not support the idea.
Figure 3: Gap Between Real Growth and Equilibrium Interest Rates (%)
For stocks, prospective higher real bond rates are damaging because they imply discounting future profits at a higher rate, and an increased recession risk. A diluted adverse impact would follow if higher real rates reflected higher trend growth.
Within the domestic economy, higher real returns are unalloyed bad news for borrowers and existing asset holders, though good news for savers. Losers include the federal government. The Congressional Budget Office forecasts that the government’s debt interest bill will be 2.5 per cent of GDP this year (14 per cent of revenues) compared with an average of 1.8% from 1993 to 2022 (10 per cent of revenues). The CBO forecasts a rise to 3.6 per cent of GDP in 2033 (almost 20 per cent of revenues). Higher yields will also result in substantial losses on the Fed’s QE-engorged bond holdings, reducing profit remittances to the government.
For heavily debt-financed corporates, higher rates are also unwelcome. Corporate debt relative to GDP has risen sharply since the pandemic, fuelled by previously cheap loans and is above previous cycles’ peak levels (figure 4). Refinancing could be problematic for many corporates next year and will be at significantly higher rates than existing loans, pressuring them to cut costs and investment. Corporate failures would adversely impact the financial sector, severely challenging the hypothesis of permanently higher real interest rates.
Figure 4: Non-Financial Corporate Sector Debt Securities and Loans/GDP (Ratio)
The housing market has not yet adjusted fully to higher real interest rates. Thus far, there is a mixed housebuilding picture – recently lower starts but accompanying more building permits, for example. However, turnover is down significantly. Existing home sales in August fell 15 per cent y/y, though house prices have recently ticked up (Figure 5). The reason house prices have bounced back recently is a lack of supply. Existing homeowners avoid moving because they want to sidestep financing a new home at a 7.5 per cent rate when their existing mortgages are hundreds of basis points cheaper. The surprising behaviour of house prices feels like a Wile E. Coyote moment that will not last, especially if employment suffers and mortgage rates fall. House prices could fall significantly over several years.
Figure 5: National House Price Index and Mortgage Rates
Impact abroad
A sustained rise in US real interest rates represents a dark cloud over the global economy. There is a partial silver lining from a resilient US economy supporting other countries’ exports. However, higher real rates in the pre-eminent global capital market mean higher real rates everywhere.
Higher US real rates make US financial assets more attractive, implying a stronger dollar on the FX markets and putting upward pressure on foreign inflation and interest rates. More capital flowing to the US will be felt most painfully by developing economies with excessive debt burdens, arguing strongly for more debt relief. However, even economies like China, without excessive external debt, will see spillovers to domestic rates from higher US yields and the increased attractiveness of the US dollar, thus crimping their economic activity.
Advanced countries will experience weaker currencies and upward pressure on their real interest rates. Higher than otherwise rates will damage growth in the eurozone and the UK, where activity is already floundering. The euro area and UK economies cannot live with real rates comparable to the US, so European real rates will fall relative to the US, weakening European currencies against the greenback. The surprising real appreciation of the euro and the pound over the last year or so points to overvaluation, leaving both currencies vulnerable.
Figure 6: Real Effective Exchange Rate Indices
Is the higher equilibrium rate story credible?
Higher than-expected US growth is consistent with the economy being able to live with higher real interest rates than previously thought. The market is currently pricing in this lasting forever, though there is a more convincing argument that this is purely temporary. Also, do not discount the Fed’s rhetoric aiming to prevent the market from prematurely pricing in an easing cycle. Otherwise, the market would price in the first cut about six months after the last hike.
The historical evidence supporting higher rates lasting for a sustained period comes from the 1994 hiking cycle. Then, the Fed doubled policy rates to 6 per cent during seven meetings, sending the 10-year yield rocketing to 8 per cent by November (Figure 7).
Figure 7: US Interest Rates 1993 – 2001
The economy experienced a soft landing. With some minor tweaks, the policy rate and bond yields remained relatively stable until the 475bp of Fed cuts in 2001. However, in the late 1990s, convincing evidence of accelerating productivity led to sustainably higher economic growth potential. That evidence is now lacking (figure 8).
Figure 8: Labour Productivity % y/y
The higher real rates forever story will fail in 2024
If higher real rates last longer, the question is how long. Some persistent factors include a large public sector deficit, an increased federal debt/GDP ratio, prospective Fed quantitative tightening and Chinese Treasury sales. Other factors, such as still-favourable corporate sector profits and unproblematic household balance sheets, will take time to erode. The key will be the extent of growth’s resilience.
Growth faces considerable lurking threats. Past interest rate hikes remain to feed through fully. As inflation and expected inflation fall, monetary policy tightens even with unchanged nominal fed funds. The housing turnover slowdown and lags in corporate debt refinancing are delaying reactions to Fed policy hikes.
Corporate debt is high relative to GDP, though the non-financial corporate debt/equity ratio has fallen. There are substantial differences between non-financial corporates, however, with commercial property, for example, under severe strain. A stronger dollar and higher rates will hurt manufacturing. Possible corporate distress next year could bleed into the financial sector.
The New York Fed’s regular estimates of the equilibrium real interest rate currently put it at around 1.14 per cent. The Fed’s longer-term real rate projections support a view of modest long-term nominal rates. We would expect a decisive turn in the economy in 2024, at which stage the higher real rates forever story will look like Swiss cheese – full of holes.
Figure 9: Estimates of Real Equilibrium Interest Rate (%, Laubach-Williams Method)
Summary and conclusions
Overall, we assess that equilibrium short-term real interest rates have increased and that some of the rise may persist for a year or so. The customarily long and variable lags between interest rates and the economy are probably more prolonged than usual. For example, previous supply chain shortages have left automobile inventories to sales ratios at deficient levels, meaning that declines in new vehicle demand will mainly at first deliver higher inventories, not lower output. Longer lags could result from currently lower headline inflation boosting real average earnings and consumption.
The higher trend growth story is doubtful since there is no productivity acceleration, such as in the late 1990s. Therefore, permanently higher equilibrium growth and r* are unlikely. Downward shocks to growth, employment, and inflation data would severely undermine the permanently higher real rate narrative. When that happens, the Fed will cut far faster than it currently projects. It is contemplating a cutting cycle starting in 2024 and ending after 2026. This rate path relies on the assumption of a soft landing. The Fed projections are not forecasts but indicate what the Fed would like to happen – a soft landing, which would accompany a smooth glide path for rates. In no way are these projections the most likely outcome. We should take the dynamics of the rate path in the Fed’s projections with a pinch of salt. The three cutting cycles since 1990 lasted about a year on average because there is seldom anything linear about downswings. Currently over-inflated stock and house prices mean the coming economic downturn will be painful, so yields will plunge alongside a sharp rate cut cycle.
The market currently has a higher r* story between its teeth. With longer-than-usual monetary policy transmission lags making a sudden economic downturn unlikely, the implication is that real yields could climb further before they fall. Thus, the higher forever real rate view will persist in the short term. The most likely catalysts for reappraisal are weaker growth, employment data, and financial stresses in parts of the corporate sector or banking. In the meantime, to rework John Connally’s 1971 comment about the dollar. “They are our bond yields, but your problem.” The rest of the world, beware.
