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Are US interest rates going to be higher for much longer?
Federal Reserve (Fed) watchers monitor market expectations of future central bank policy. Fed fund futures are, of course, the favorite of commentators, but those who want to go further often have to make do with spot rates, which lack the precision to measure expectations, be it for the European Central Bank (ECB) or any other G10 central bank. In this weekly edition of Simply put, we explain why the market is now convinced that rates will be higher for much longer.
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Need to know:
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What does the market expect?
The solution is to use one of the 'spline' models that are so feared by young financial engineers. Yet these models have a lot to teach us. In the case of the US, for example, they allow us to look at what Fed fund futures do not show: what is the 'end point' of Fed rates, the Fed's policy rate in five or 10 years' time, as anticipated by the market.
What we think is important at this stage of the process is precisely this: despite the recent fall in rates, if the market continues to expect Fed rates to be at 5% for the next decade, then let's not bury the 'higher for longer' idea just yet. Here is an overview of recent developments in long-term expectations of the Fed's behaviour, with a few surprises thrown in for good measure.
Are you more of a Nelson & Siegel or Svensson quant?
Fed fund futures are an extraordinary instrument: they enable us to measure, with a minimum amount of noise, the average rate at which the market expects to be able to borrow money on the Fed fund market month by month. In so doing, they allow us to measure the market's expectations of future US central bank monetary policy.
This huge advantage comes with a tiny drawback: while the first 12 maturities are sufficiently liquid to make their measurement trustworthy, the same cannot be said of subsequent maturities. In most cases, this is not a real constraint as we are usually interested in the year's monetary policy. There are, however, a few special cases where we need to look at what is known as the 'end point' of central bank rates, i.e., the anchor that binds long-term expectations.
To put it simply, it is sometimes important to measure what the market expects the Fed or the ECB to do in five or 10 years' time, but Fed fund futures are useless for this aim. We need to estimate these expectations, i.e. deduce them from spot rates that are sufficiently liquid to carry information. Nelson and Sigel, followed by Svenssonv, have proposed atheoretical models of the yield curve based on well-chosen functional forms for spot rates from which it is possible to deduce forward rates, in particular instantaneous forward rates. These rates are essential for monetary policy as they are the rates for borrowing or lending money overnight, 'forwards' in a given number of months or years - in short, the policy rate. Using Nelson and Siegel's model, figure 1 shows how these expectations have been distorted from date to date between December 2022 and today, for forward horizons ranging from one to 10 years.
Figure 1. Expected Fed fund rates for 1 to 10 years between December 2022 and January 2024
Source: Bloomberg, LOIM.
Let's not bury the ’higher for longer’ idea
This chart illustrates the Fed’s struggle to convince the market of its intention to raise policy rates and keep them higher for longer. Figure 1 shows how slowly this battle has progressed, from small expected rate hikes (late 2022), to rate hikes that were not expected to last (June 2023), to a post-higher-for-longer pivot (December 2023).
The revision of expectations at the start of the year saw this term structure rise and simultaneously flatten: expected 10-year Fed rates were close to 5%. So, as surprising as it may seem, it was in the days after the Fed's pivot that long-term expectations began to rise. 'Higher for longer’ continues to form the narrative for the decade to come - at least that is what the markets are now pricing.
This change in expectations can be seen even more clearly in figure 2. The current situation is in sharp contrast to what we have seen since 2009: expected Fed rates from one to 10 years are now high overall, reflecting the fact that the Fed is expected to keep rates high for a long time to come. Pessimists will point to the existence of a hard-to-measure ’term premium’, which should cloud the clarity of this picture. However, the ’higher for longer‘ argument is therefore more valid than ever. As long as this belief remains anchored in markets, long rates cannot collapse for good. And the Fed's latest meeting will do nothing to alter this belief.
Figure 2. Evolution of Fed rate expectations since 2009 implicit in the cash yield curve
Source: Bloomberg, LOIM.
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Simply put, the market is now convinced that rates will be higher for much longer. That needs to change for rates to markedly decline. |
Nowcasting corner
The most recent evolution of our proprietary nowcasting indicators for global growth, global inflation surprises, and global monetary policy surprises are designed to track the recent progression of macroeconomic factors driving the markets.
Our nowcasting indicators currently show:
- Growth continued to rise again this week, particularly in the US
- Inflation remained stable over the week, despite the vast majority of data rising over the month
- Monetary policy continued its very recent rise, particularly in the US
World growth nowcaster: long-term (left) and recent evolution (right)
World inflation nowcaster: long-term (left) and recent evolution (right)
World monetary policy nowcaster: long-term (left) and recent evolution (right)
Reading note: LOIM’s nowcasting indicator gather economic indicators in a point-in-time manner in order to measure the likelihood of a given macro risk – growth, inflation surprises and monetary policy surprises. The nowcaster varies between 0% (low growth, low inflation surprises and dovish monetary policy) and 100% (the high growth, high inflation surprises and hawkish monetary policy).
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