Slow growth for US in­ter­est rates

Financial Mirror (Cyprus) - - FRONT PAGE -

The US Fed­eral Re­serve’s new pol­icy state­ment will, as usual, be an­a­lyzed in ex­cru­ci­at­ing de­tail in the days ahead, as in­vestors seek guid­ance on when and how quickly in­ter­est rates will be raised. No­tably, the word “pa­tient” does not ap­pear, and the Fed has sig­naled that it may raise its bench­mark rate as early as June. But the par­tic­u­lar word­ing is far less telling than the con­text in which the state­ment is be­ing re­leased.

In fact, un­cer­tainty about mon­e­tary pol­icy in the United States has been the lead­ing driver of fi­nan­cial-mar­ket volatil­ity this year. Af­ter all, the po­ten­tial ef­fect of in­ter­est-rate hikes on the US yield curve has a ma­jor im­pact on the pric­ing of all global as­sets.

But three fac­tors sug­gest that in­vestors are over-em­pha­siz­ing the risk of a curve repric­ing. First, eco­nomic de­vel­op­ments will likely lead the Fed to ex­hibit cau­tion when it comes to the process of rais­ing in­ter­est rates. Sec­ond, even if the Fed acts quickly, in­vestor ap­petite for re­turns will an­chor yields. Third, the tech­ni­cal fea­tures of the mar­ket will en­sure strong de­mand for US Trea­sury bills.

Let us begin with the rel­e­vant eco­nomic de­vel­op­ments. The con­sen­sus nowa­days is that the US econ­omy is grow­ing steadily, with the lead­ing in­di­ca­tors point­ing to­ward fur­ther ex­pan­sion, and la­bor-mar­ket data sur­pass­ing ex­pec­ta­tions. Job cre­ation is strong, with to­tal non-farm pay­roll em­ploy­ment hav­ing in­creased by 295,000 in Fe­bru­ary and the un­em­ploy­ment rate fall­ing yet again, to just 5.5%.

But some in­di­ca­tors still have the Fed con­cerned. The Per­sonal Con­sump­tion Ex­pen­di­tures de­fla­tor re­mains well be­low the 2% tar­get. The core con­sumer price in­dex, to be re­leased next week, is ex­pected to show a year-on-year in­crease of just 1.7% – or even less, if the lower oil price feeds through from head­line to core CPI. And real wage growth stands at less than 2%, which is be­low the level deemed nec­es­sary by the Fed to un­der­pin a sus­tain­able ac­cel­er­a­tion in con­sumer spend­ing.

On top of al­ready mod­est in­fla­tion ex­pec­ta­tions – char­ac­ter­ized by a five-year break-even in­fla­tion rate of 1.9% – the dollar has ap­pre­ci­ated by around 10% this year, and by al­most 25% since the be­gin­ning of last year. Given the de­fla­tion­ary im­pact of a stronger cur­rency – and the Fed’s gen­eral in­tol­er­ance of de­fla­tion – there is good rea­son to be­lieve that the Fed will ex­er­cise cau­tion in rais­ing in­ter­est rates.

Even if the Fed ig­nores de­fla­tion­ary pres­sure and hikes in­ter­est rates more quickly, medium- and long-term rates are still likely to be an­chored, given how lit­tle yield is avail­able else­where in the world. Yields on Ger­man Bunds are now neg­a­tive out to eight years.

In Europe’s pe­riph­eral economies, tenyear yields are edg­ing closer to 1%, as the Euro­pean Cen­tral Bank pur­sues a EUR 1.1 tril­lion ($1.3 tril­lion) quan­ti­ta­tive-eas­ing pro­gram. And, in Ja­pan, ten-year yields are be­low 0.4%.

Lend­ing to the emerg­ing economies is hardly at­trac­tive, ei­ther, with even the riski­est economies of­fer­ing low hard­cur­rency yields. In­deed, even Rus­sia – whose mil­i­tary in­ter­ven­tion in Ukraine has led the West to im­pose strict eco­nomic sanc­tions – of­fers an­nual yield of less than 6% on tenyear bonds.

Given such low yields in most of the world, in­vestors will be ea­ger to take ad­van­tage of the rel­a­tive value op­por­tu­nity of­fered by ris­ing US in­ter­est rates. Add to that Amer­ica’s safe-haven sta­tus, and the fact that any re-pric­ing of US rates surely would re­flect an eco­nomic resur­gence, and the bid for US Trea­suries should be ex­cep­tion­ally strong. In this con­text, in­ter­est rates would re­main capped, mit­i­gat­ing the dis­or­derly bond-mar­ket sell-off.

The fi­nal, tech­ni­cal rea­son why in­ter­est rates are not likely to rise ex­ces­sively is that years of cen­tral-bank pur­chases and a shrink­ing US bud­get deficit have made US Trea­suries scarce. In­deed, so-called “repo” ac­tiv­ity – that is, the sale of a US Trea­sury obli­ga­tion that the seller prom­ises to buy back later at a slightly higher price – has de­clined con­sid­er­ably, with the bal­ance of such trans­ac­tions hav­ing fallen from $5 tril­lion be­fore the cri­sis to $2.5 tril­lion to­day. Both the two-year and five-year US repo rates have been pushed pe­ri­od­i­cally into neg­a­tive ter­ri­tory, ow­ing to the com­bined ef­fects of risk-averse be­hav­ior, in­vestor delever­ag­ing, and stricter bank­ing reg­u­la­tion.

Though US mon­e­tary pol­icy un­doubt­edly ex­erts sig­nif­i­cant in­flu­ence on global mar­kets, fears sur­round­ing the di­rec­tion of US in­ter­est rates may be over­done. Though the Fed may no longer be promis­ing pa­tience, the cur­rent fi­nan­cial en­vi­ron­ment im­plies that in­vestors should not, for the time be­ing, an­tic­i­pate a ma­jor hike.

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