This is the first chart1 I look at each day: expectations for future US interest rates. I include the view of the technocrats at the Federal Reserve Bureau (Fed), updated quarterly, plus that of investors, inferred from live Treasury prices:
One only has to look at last year to understand why US interest rates or ‘the risk-free rate’* (*I prefer the phrase ‘lowest risk investment’ because US Treasuries are not without risk, a view shared by the ratings agencies) matters: the more investors can earn on dollar cash, the less they are willing to pay for all other investments.
As can be seen from the chart, there has been a meaningful shift in investors’ interest rate expectations so far this year, with investors gravitating towards the Fed’s view from December (they are set to update their forecasts next month). As a result, interest rate expectations for the end of 2023 are up by 30 basis points and Treasuries are looking more attractive.
Both sides agree that interest rates are going to peak fairly soon and then come down, implying that monetary policy is in restrictive territory at current levels of around 5%. Longer term, 5% nominal interest rates do look high when aligned to a ~2% inflation target, implying a real yield on cash of 3%. This would take serious impetus out of a US economy which can only grow at around 2%2 if history is anything to go by: why take a chance on a business in a low-growth economy when you can earn a higher real yield on cash?
If this view is proven to be correct, it will have been a moderate tightening cycle by historical standards: using the past ~25 years as a guide, US inflation topping 9% should require materially higher interest rates than 5% to arrest3. This leads to uncomfortable comparisons with the 1970s when the initial hiking cycle was eventually proven to have been too timid. On the other hand, the amount of tightening we’ve seen (i.e. where interest rates are today compared to where they started) looks more on par with this same history, suggesting policymakers have in fact made decisive moves.
At the start of the year, investors were predicting an imminent pivot by the Fed. Without trying to be too precise – overconfidence in forecasts is a pitfall in our view – we felt imbalances could take longer to work out, as was the case post the financial crisis, which will ever be remembered for its ‘looser for longer’ monetary policy. Add to that the fact that inflation is the enemy of any investment that pays a fixed amount in nominal terms, and it’s clear we should be patient and wait for yields to price in this risk. Yields remain below their peaks from last year, but with inflation slowing, they are starting to look attractive. Sources: 1FEDL01 Index, YCGT0025 Index and DOTS