Behind the headlines driving financial markets, long-term interest rates remain high. Political unrest on both sides of the Atlantic and turbulence in the artificial intelligence sector have overshadowed this interest rate situation, but it remains very present. While markets have started to price in the risk of the Federal Reserve (Fed) raising rates over the next 18 months, US 10-year real rates remain elevated. If we consider the situation from a macro perspective, the prospect of solid growth in the US (which is supported by consumption) remains a pillar of recent valuation increases – the ‘Trump call’. Yet, could the rise in rates challenge this scenario? This week, we aim to uncover whether interest rate fluctuations will cause US growth to slow.
The short and long of rate levels
When discussing rate hikes, it's helpful to distinguish between short-term and long-term rates. Short-term rates are explicitly controlled by the central bank and are an essential weapon in its fight to control inflation. Long-term rates were instrumentalised during the quantitative easing decade but also reflect the tension between capital supply and government financing needs (or the Treasury in the US).
Over the past four months, US short-term rates have been lowered by about 100 bps but this hasn't pulled long-term rates lower. US 10-year rates have actually increased by 95 bps (from mid-September to the end of January), leading to the formation of a ‘term premium’. According to the Adrian, Crump and Moench model, this term premium was negative in September but approached 50 bps in January 2025, implying the market is demanding a risk premium for holding Treasury debt that has not been seen since 2014.
The question that concerns us is: will this decrease in short-term rates and increase in long-term rates impact consumption and investment in the US? This question is crucial for the investment world, as US consumption has been a pivotal factor supporting global demand over the past two years.
Read more: Up, down and all around: what’s happening with inflation?
Figure 1 presents an initial answer, showing the estimated impact of a 100 bps increase in both short-term and long-term rates by putting them on equal footing. As short-term rates have recently decreased, readers should mentally convert the effect of a decrease by inverting the grey bars on the chart, which allows for an easier comparison of the magnitude of both effects. The key points are:
- A 100 bps Fed rate increase has relatively the same effect over two years as the same increase in long-term rates: a 1.6% and 1.8% reduction in real consumption growth or a negative contribution to economic growth of about 1.2% (consumption represents about 70% of US growth)
- However, the Fed rate increase has a much smaller effect on investment than the equivalent increase in long-term rates over this time horizon, respectively a 1.7% versus 7.2% reduction in real investment growth, or a 0.34% and 1.44% reduction in the contribution to total real growth (investment contributes 20% to US growth).
As shown in this simulation, a 100 bps decrease in short-term rates can counteract an equivalent increase in long-term rates for consumption but not for investment.
FIG 1. Simulated effect of a 100 bps increase in Fed funds rate vs 10-year Treasury rates on US consumption and investment over two years1
What about consumption?
The calculations in Figure 1 cover a two-year time horizon, but are the effects similar in the short term? Figure 2 presents a quarterly simulation over three years. If we focus on the first four quarters (ie the scenario for 2025 given the timing of the rate changes we are examining here), the conclusion appears different (again, as short-term rates have decreased, readers should invert the grey bars on the chart):
- Over a year, the rise in long-term rates points to a 1.5% decline in consumption, while the fall in short-term rates stimulates consumption by about 0.75%, providing a net effect of -0.75%
- In the same period, investment doesn’t appear to be at risk, with its decline occurring after the one-year period.
FIG 2. Quarterly simulation of the impact of a 100 bps increase in short-term and long-term rates on US consumption and investment2
The crucial point is that the recent rise in long-term rates is likely to be negative for US consumption this year – consumption is widely expected to grow by 2.4%, with economic growth at 2.2%. Higher long-term rates could cut about 0.5% from real growth if they don't fall back soon.
In our view, a key risk for 2025 is that the US could enter a slowdown phase while the rest of the world continues on a path of recovery, which might raise questions for global asset allocators. For now, the indicators pointing to a US slowdown are more on the investment side, with 75% of data showing signs of deterioration in our growth nowcasting signal. A decline in US consumption could add to this deterioration in the coming quarters.
What this means for All Roads
Our current asset allocation remains balanced between cyclical and defensive assets and our market exposure remains close to its long-term average. However, our macro signals show a low conviction, with growth oscillating between recovery and slowdown, primarily in the US. Trends in cyclical assets remain positive, but are not encouraging us to abandon our bond exposures and volatility strategies, highlighting the effect of our risk model.
Simply put, the rise in long-term rates could weigh on US consumption despite Fed rate cuts.
To learn more about our All Roads multi-asset strategy, click here. Macro/nowcasting corner
The most recent evolution of our proprietary nowcasting indicators for global growth, global inflation surprises, and global monetary policy surprises is designed to track the recent progression of macroeconomic factors driving the markets.
Our nowcasting indicators currently show:
- Growth data continues to indicate a recovery, but the diffusion index in the US is now below 50%
- Inflationary pressures continue to ease: our indicators are high but are expected to decrease
- Our monetary policy signals continue to point to accommodative central banks.
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 gathers 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).
