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Are Higher Interest Rates a Threat to the Market?

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This is an excerpt from our most recent Economic Outlook report. To access the full PDF, please click here

With interest rates continuing their upward trend, the question arises. How is this rise going to affect the U.S. economy and risk markets? In order to answer this question better, we need to remind ourselves. Interest rates do not rise in a vacuum. It is important to take a look under the hood of the economy, in order to understand how interest rates are rising. With the U.S. economy continuing to become stronger -- and inflation expectations building -- we see a slight increase in the long end of the curve. However, we see a very strong move at the short end.

The 3D chart below shows 36 years of U.S. yield curve history at once. The depth is 1yr, 2yr, 5yr, and 30yr yield curves over time. The height is the absolute 10-year yield. At the back of the chart, the 30-yr mortgage yield has been falling, from over 14.0% in 1982 to just above 3.0% in recent years.  At the front of the chart, in 1982, the Fed Funds rate was near 13.0%. It is 1.75% now, after rising from 0.0%, the incredible crisis level from 2008 to 2015.

Now, let’s go back to 2D. Risk-free Treasury bond markets have seen a major flattening of the U.S. yield curve. This compression started as we entered 2015.

You can see from 10-year to 2-year spread, shown below.

We expect that -- across the rest of 2018 -- U.S. fixed income markets should see a continuation of this theme: Rising risk-free U.S. Treasury rates at the short end of the curve, and a subdued reaction at the long end.

Why is that? Outside the U.S., foreign economies move in synchronized business cycles. But those cycles are at an earlier stage compared to the U.S. one. So, non-U.S. economies are universally experiencing a labor markets becoming tighter, and should see stronger inflation pressures as well. But, their domestic inflation pressures will come at a later time.

That means central banks outside the USA continue to apply deep monetary accommodation and “QE” to their bond markets without much worry. In turn, relatively speaking, the long end of the U.S. yield curve still looks very attractive to foreign investors. On top of that, consistent long-term U.S. Treasury demand by private foreign institutions has also contributed to the flattening of the U.S. yield curve.

Taken together, the two groups of global bond market actors keep a lid on how far U.S. long-term yields can rise.

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