Why are interest rates rising?

The interest-rate environment in the US could not be worse, due to both the country’s fiscal situation and hawkish monetary policy. In this weekly instalment of Simply put, we analyse these two factors and their impact on rates.

The duration factor

The combination of these two factors makes for an incredibly complex analysis of interest rates, and the 'duration' factor at this stage of the cycle remains one of the key elements of any investment policy (we discuss our current exposure here). 

This sense of complexity is due to the difficulty in isolating the factor behind the rise in long-term rates. After all, the Federal Reserve recently told markets that it would not be raising interest rates any further, and yet the day after this announcement, a bear steepening began impacting all asset classes. 

Here we look at this rise in rates to clearly illustrate that the tax premium¹ remains low and that rates are rising further because of an adjustment in real rates. The question that naturally arises is: what is driving this rise in real rates? 

One factor seems to be central: household savings (the supply of finance) are falling, while investment (the demand for finance) remains high. With strong demand and shrinking supply, the price of money (real rates) naturally rises and we may not have seen the end of it yet. Considering this, below are a few points that we think are essential.  
 

Real rates vs fiscal premium

There are various ways of distinguishing between the fiscal premium, the inflation premium and real rates, but only one is not model-dependent. This market approach consists of summing up a country's credit default swaps (fiscal premium), the corresponding inflation swaps (inflation premium) and then turning the remainder, which completes the explanation of nominal rates, into the real rate premium. 

This is illustrated in figure 1, which shows how the three premiums have evolved since 2008. The recent spike in US 10-year yields is due to the tax premium and real rates:

• Between December 2022 and September 2023, the tax premium rose by 20 basis points
• Over the same period, real rates rose by 40 bps
   

The impact of this first factor remains limited, but it is undeniable and too recent to be ignored. It can only rise further if US fiscal policy is perceived as reckless – which is hard to say at this stage, but it’s certainly a risk that we would currently classify as a geopolitical one. More worryingly, the trend in ’pure’ real rates may continue to rise and keep weighing on bond markets for one simple reason: demand for financing may remain strong while supply is falling.


FIG 1. Breakdown of US 10-year yields (expressed as a %)
 

Source: Bloomberg, LOIM at October 2023. For illustrative purposes only.

The savings story continues

Much of the attention of macro-observers has focused on the dynamics of US household savings. Post-pandemic, the strength of household savings enabled the recovery to be particularly strong and has been credited with providing much of the resilience of the US economy during the intense hiking cycle. 

What is being given less credit is the slow transmission of the Fed's monetary policy. This mainly implies that increases in short-term interest rates push up long-term interest rates, which in turn weigh on corporate investment prospects as the cost of capital rises. However, the cost of capital also includes real interest rates, which have remained relatively low due to the depth of excess savings. 

More recently, these savings have been gradually spent by households to maintain their standard of living in the face of rising inflation. The use of savings has occurred at the same time as a recovery in business investment, and these two developments combined may explain much of the recent rise in real interest rates. 

Figure 2 illustrates this rise in real rates and its concomitant fall in household savings as a ratio of GDP. The graph is accompanied by a projection for the coming quarters, which shows the level that real rates could reach if savings continue to disappear in order to finance consumption. From the current level of 1.7% (excluding the tax premium), it could well go close to 2.5%. 

The consequence would soon become apparent: when the cost of capital exceeds the real return on investment so significantly, fixed capital formation falls back – and with it, real growth. This would drive a landing that could well be less than soft. 

So watch out for real interest rates and their link to the stock of savings: normalisation is not necessarily a good thing from the point of view of the current cycle.


FIG 2. US 10-year real rates vs savings as a ratio of GDP
 

Source: Bloomberg, LOIM at October 2023. For illustrative purposes only.
 

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 markets.

Our nowcasting indicators currently show:

• Growth has declined marginally this week along with US services data 
• Inflation remains on an upward trend that began in the middle of the year, driven this week by US and Chinese data 
• Some form of monetary-policy moderation should be expected from central banks over the coming weeks

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)

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).

1 This tax premium shows the rates compensation asked by investors to accept onboarding the credit profile of the issuer (in this case, a government).

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