The rise of US interest rate
MARKET participants have been keenly watching moves in the rates market to determine whether Treasury yields, after many false starts, are finally ready to break higher and, if so, to what level. Last month, the 10-year yields breached the much-watched 3.05 per cent technical level with little fanfare, but have since promptly reversed its course on the heels of geopolitical worries and heightened concerns about trade policy. Still, with the US economy is poised to deliver solid growth in the second half of 2018 (2H18), with inflation largely on target, wages accelerating, and the Fed signaling a steady diet of hikes for the foreseeable future. The question of what a higher rates complex means for other asset classes remains a critical issue for asset allocators.
Of course, the genesis of the concern about higher rate levels is the widely held view that the low rates environment created by global central banks following the global financial crisis (GFC) has artificially supported risky asset valuations.
Many believe that any transition away from this backdrop will not likely be smooth. How- ever, instead of drawing a line in the sand at a given yield level, it is useful to examine the underlying circumstances that could drive yields higher in order to gauge the spillover effects more accurately.
In this report, we look at two states of the world that provide alternate paths to a higher rates complex.
We reckon that the 10-year yields are unlikely to breach 3.5 per cent in this cycle in either scenario.
In the first, the business cycle would extend and long-run neutral rate estimates, currently at 2.75 to three per cent, could be revised by up to 50bp. In the second, term premium could rise by 50bp, reverting to its pre- crisis average.
A bigger increase is unlikely, given that structural factors have been key drivers of the multi-year decline in the neutral rate and term premium. A large simultaneous increase in both is also unlikely, starting from current levels.
Higher US risk-free rates are likely to be less disruptive for emerging markets, especially if the emerging markets’ ( EM) growth prospects are also on the rise. Term premium- driven increases are likely to be more negative for EM assets via portfolio and banking sector channels.
Separately, higher Fed interest rate environment could cause higher a doller index strength which precipitate an exodus of duns leaving EM economics and reinvest in US shores. Malaysia is no exception.