Interest rate bump
Interest rates are rising. First because of rising inflation expectations, but in recent weeks also because of rising real interest rates. The reason for this is the improved growth prospects for the US economy. Vaccination is going well there. Biden wants every American to be vaccinated before Independence Day. The rapid vaccination ensures that the American economy can open up as early as the second quarter. On top of that comes a new aid package of USD 1.9 trillion, roughly equivalent to 10 percent of US GDP. Then there is an absurd amount of additional savings, now around 1.6 trillion, and last year Americans also got 6.6 trillion richer thanks to rising stock markets and rising house prices. Typically, 3 to 5 percent of this increase is consumed, so we are talking about an additional 1 to 2 percent of GDP growth. There is therefore a chance that the US economy will grow by 7 to 8 percent this year, instead of the IMF’s last estimate of 5.1 percent at the end of January. That is almost equal to the 8% growth of the Chinese economy this year, something we have not seen so far this century.
US ten-year yields may rise further towards 2 percent this year, but real interest rates are likely to remain negative. Inflation expectations could move towards the 2.5 to 3 percent mark on the back of strong growth and base effects, with purchasing managers seeing more inflation in the pipeline. An interest rate of 2 percent for an economy growing at 8 percent and an inflation rate of 3 percent is still extremely low. This has to do with the buy-back policy of the US central bank, but also the low-interest rates in Europe and Japan are keeping US interest rates low. Over the last decade, interest rates have become less and less a reflection of future inflation and growth expectations and more a result of monetary policy. This monetary reflation policy rests on negative real interest rates, necessary to let the economy grow faster than the debt mountain.
Higher interest rates put pressure on the valuation of equities, but from a historical perspective, even an interest rate of 2 percent is still extremely low. Japan is the biggest winner in case of rising interest rates; emerging markets are traditionally vulnerable. Fortunately, the current account surplus of emerging markets is at its highest level in 15 years. Another important difference is that interest rates are rising for the right reasons this time, namely because the economy is doing much better. We are coming out of recession and are at the beginning of a new cycle. In recent decades, interest rates have mostly risen because central bankers wanted to curb economic growth and thus the potential rise in inflation. This time around, interest rates are allowed to rise, provided that a significant part of the increase is driven by inflation expectations and not by a further rise in real interest rates.
The influence of central bankers on ten-year interest rates is still considerable. By indicating that interest rates will remain low for a longer period, they also put pressure on long-term interest rates. Central bankers can even make the buying policy dependent on the level of interest. Such an interest ceiling is something the Japanese central bank has already implemented, but it is only necessary if rising interest rates put too much of a brake on growth or because financial stability is at risk (read: when share prices fall). One full percentage point rise in interest rates historically depresses new home sales by 20 percent and quickly shaves one percent off GDP. That is in the past; today’s low interest rates make the economy much more sensitive to interest rate fluctuations. The average term of a US mortgage today is 10 years and, thanks to the current low-interest rates, corporate bonds have an average term of 9 years. That makes the economy more sensitive than before to rising interest rates.
The US central bank is doing everything it can to keep the rise in interest rates manageable. According to Powell, actual unemployment in the United States is around 10 percent, mainly because of the large number of permanently unemployed. Nevertheless, the Fed will probably not go so far as to introduce an interest rate ceiling, an interest rate level above which the central bank will buy up everything. Such a measure would almost certainly create more bubbles. Powell will probably stick to his words. Moreover, nominal interest rates may well rise, as long as real interest rates remain negative. In recent months, the Federal Reserve has made it perfectly clear that higher inflation rates will be tolerated. The FOMC is now talking mainly about inclusive growth and emphasising the still-high unemployment rate at the bottom of society. Inflation may well exceed 2 percent for a year. Powell has recently been supported by Janet Yellen, who is clearly in favour of even more fiscal stimulus. She is not waiting for the positive effects to be undone by the Fed. Yellen is even pressing for more financial support in the G7. She believes that higher wages ultimately lead to higher productivity and thus more economic growth. The policies of Powell and Yellen do not allow for a sharp rise in interest rates. So, for now, it is not much more than an interest rate hump that the market needs to step over.