IN­TER­EST RATES Bond mar­ket has Fed hawks on short leash

Business Day - - Opinion - ● Kan­tor is chief econ­o­mist and strate­gist at In­vestec Wealth & In­vest­ment. He writes in his per­sonal ca­pac­ity.

The global fi­nan­cial mar­kets are re­act­ing to two forces at work: what Fed­eral Re­serve chair Jerome Pow­ell might do to the US econ­omy with in­ter­est rates, and what Pres­i­dent Don­ald Trump might do to the Chi­nese econ­omy with tar­iffs.

In­ter­est rates set by the Fed may or may not prove help­ful for the US econ­omy, given its un­known fu­ture path. It is not the pres­i­dent but mar­ket forces that are re­strain­ing in­ter­est rate in­creases in the US. Their ab­sence is help­ful to share prices, all else — ex­pec­ta­tions of earn­ings growth, for ex­am­ple — re­main­ing un­changed.

It is the US bond mar­ket it­self that has elim­i­nated any ra­tio­nal ba­sis for the Fed to raise short-term in­ter­est rates. Should it pur­sue any ag­gres­sive in­tent with its own lend­ing and bor­row­ing rates, in­ter­est rates in the US mar­ket­place, beyond the very short­est rates, are very likely to fall rather than rise.

Hence the cost of fund­ing US cor­po­ra­tions that typ­i­cally bor­row at fixed rates for three or more years and the cost of fund­ing a home that is mostly fixed for 20 years or more, would likely fall rather than rise. And so make credit cheaper.

The term struc­ture of in­ter­est rates in the US has be­come ever flat­ter over the past few months. The dif­fer­ence be­tween 10-year and two-year in­ter­est rates of­fered by the US trea­sury has nar­rowed sharply. Ten-year loans now yield only frac­tion­ally more (0.13% per an­num) than two-year loans. This dif­fer­ence in the cost of a short- and long-term loan could eas­ily turn nega­tive — that is longer-term rates fall­ing be­low short rates — should the Fed per­sist with rais­ing its rates.

It is un­likely to do this beyond the 0.25% in­crease widely ex­pected in De­cem­ber for term struc­ture rea­sons.

The US cap­i­tal mar­ket is not ex­pect­ing in­ter­est rates to rise in fu­ture. Given the op­por­tu­nity to bor­row or lend for shorter or longer pe­ri­ods at pre­de­ter­mined fixed rates, the longer-term rate will be the av­er­age of the short rates ex­pected over the longer pe­riod. Lend­ing for two years at a fixed rate must be ex­pected to re­turn as much as would a oneyear loan rene­go­ti­ated for a fur­ther year at pre­vail­ing rates. BRIAN KAN­TOR Other­wise money would move from the longer to the shorter end of the yield curve or vice versa, to re­move any ex­pected ben­e­fit or cost.

By in­ter­po­la­tion of the US trea­sury yield curve, the rate ex­pected to be paid or earned in the US for a one-year loan in five years’ time has sta­bilised at about 3.2% per an­num, or only about 0.5% per an­num more than the cur­rent one-year rate. These mod­est ex­pec­ta­tions should be com­fort­ing to in­vestors. They are not ex­pec­ta­tions with which the Fed can eas­ily ar­gue, for fear of send­ing rates lower not higher.

The mar­ket be­lieves in­ter­est rates will not move much higher be­cause mar­ket forces will not act that way. In­creased de­mands for loans at cur­rent in­ter­est rates are not ex­pected to ma­te­ri­alise. They are con­sid­ered un­likely be­cause real growth in the US is not ex­pected to gain fur­ther mo­men­tum and is more likely to slow down.

Fur­ther­more, given the out­look for real growth, in­fla­tion is un­likely to pick up mo­men­tum. Should it do so, lenders would de­mand up­front com­pen­sa­tion in the form of higher yields.

The mar­ket of course might change its col­lec­tive mind, redi­rect­ing the yield curve steeper or shal­lower and in turn giv­ing the Fed more or less rea­son to in­ter­vene help­fully. In­ter­est rate set­tings should not un­set­tle the mar­ket­place. They are very likely to be pro­cycli­cal.

How­ever, the more im­por­tant known un­known for the mar­ket will be Trump and his eco­nomic re­la­tion­ship with the rest of the world. Per­haps the pres­i­dent him­self will be help­fully con­strained by the mar­ket­place. The ap­proval of the mar­kets would surely help his re-elec­tion prospects.

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