INTEREST RATES Bond market has Fed hawks on short leash

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.