This is an excerpt from our most recent Economic Outlook report. To access the full PDF, please click here
Interest Rates in 2018
Jointly led by Jerome Powell’s Fed and Draghi’s ECB, the major theme across 2018 around the globe should be a (cross your fingers, it is controlled?) rise in interest rates. Central banks around the world are poised to follow the ECB and reduce the amount of monetary stimulus in the second half of the year.
Strong macro expansions everywhere, and tighter labor markets, along with prospects of positive U.S. tax cut effects, continue to provide ample fundamental reasons for the Fed to stay on their 3 rate hike path throughout the year.
This leads to the question. How is this going to affect the risk-free yield curve and in particular the long end of the curve? January 2018 has been marked by an uptick of rates all along the yield curve. The changes were more pronounced at the short end.
The long end of the curve continues to be dominated by a number of factors, such as QE, inflation and relative GDP growth expectations, and more important than ever: the supply and demand for U.S. Bonds. Long-term U.S. bonds continue to offer a safe yield for foreign investors. But it is less safe now. This may add new pressures, as rates around the globe hopefully rise gradually across 2018. The graph below illustrates the development of long term yields over the last 35 years:
Notice how the 3D curve folds up -- in periods immediately preceding past recessions, most prominently in 2007? This type of compression (between short and long-term yields) decreases profit margins for the core business loan model of the banking sector. They borrow cheaper money on the short end and lend fatter at the long end. As that differential gets squeezed, less profit in core bank lending siphons liquidity out of commerce. While record high corporate cash holdings are making headlines these days, this does not reflect increasing debt levels and financial leverage --due to multiple years of extremely low financing costs. As the Fed move rates higher, a flattening of the curve will pinch lending, in particular to smaller companies that are more reliant on outside bank lending.
In 2004, former Fed Chairman Alan Greenspan also stated this conundrum -- long run rates would not react to his changes to the short end. If your eye focuses on the long end of the curve in the graph above – or the 10-year slice of the 3D graph as depicted below -- it becomes apparent. Any lack of responsiveness of longer rates to the short end of the curve is not an outlier. Rather, the long end has danced to a different drum for almost four decades. Compared to short-end volatility, long run rate changes have followed an overall downward trend since the spiky inflation-driven levels of 1982.
This downtrend in long-run rates is in line with lower levels of GDP growth and inflation, reflecting economist Larry Summers statement of an era of secular stagnation in real activity, assisted by weaker demographics and global labor cost pressure. Given this observation -- at this point of controlled policy direction -- we project the long end of the curve is going to inch higher throughout 2018. The upward potential could be limited and will most likely remain below 3.25% throughout 2018.
But stay tuned. Control is not certain.
SECTION 3: CONCLUSIONS
As interest rates rise, under a jointly controlled and likely coordinated global policy, investors should pay close attention to the overall shape of the term structure of risk-free rates…and pay the most attention to the long end of the curve.
Influential stock strategists care about the 10-year the most. News headlines and the institutional actors will heed their comments. Any absence of central bank control, anywhere along the yield curve, will have the most serious consequences.
A continuous flattening of the rates yield curve could eventually lead to an inversion of that curve in the next year or two. This has been a predictor of recessions in the past. While there is no guarantee this history will repeat, frothy risk-driven financial markets will interpret this as a strong negative sign, in any case.
In sum, any sudden rise of long-term rates can lead to a healthy correction/pullback in frothy, euphoric, single-minded, risk-driven financial markets. It will have a much more debated, and likely a longer-term effect, on overall real economic activity.
If you own high yield corporate bonds, given their multi-year credit spread tightness, now is a good time to sell them.