In the Federal Reserve’s September Summary of Economic Projections, policymakers indicated that the long-run neutral federal funds rate, or what economists refer to as r-star, has moved higher toward 3%.
Gone are the days of easy money and secular stagnation, with near-zero interest rates.
The implied logic of that forecast has prompted investors and market participants to reset rates to a higher level.
A big reason for this resetting is the resilience of the American economy. Despite the shocks unleashed by the pandemic and the inflation that followed, the economy has created an average of 233,000 jobs a month over the past six months.
Gross domestic product in the third quarter is likely to exceed 3% and has momentum heading into the final three months of the year. And with productivity rising and full employment (u-star) at 4%, the U.S. economy is likely to grow at a faster pace than the current long-term growth (y-star) of 1.8% suggests.
A new era has arrived in the American economy. Gone are the past 15 years of easy money and secular stagnation, with near-zero interest rates and unorthodox polices to avoid a depression.
In its place is a rapidly developing new framework in which the term premiums placed on debt by investors are positive, reflecting higher long-term trend growth and a policy rate that is not zero on a nominal basis and negative on an inflation adjusted basis.
In this framework, debt is priced within a matrix of risk that recognizes geopolitical tensions, the size of federal deficits, political dysfunction and potential losses because of inflation.
The result is falling bond prices and higher of yields across the entire Treasury curve.
While we recognize that the long-term demographic challenges associated with the global savings glut that dampened rates over the past two decades will not fade anytime soon, the gravitational pull downward on growth, inflation and rates appears to have lifted after a long slumber.
The term risk premium
One simple way is to estimate long-term interest rates is to add real GDP growth to the expected rate of inflation. If growth is 2% and inflation settles around 2.5% to 3%, that implies a 10-year bond yield of 4.5% to 5%.
Based on this approach, the move upward in long-term interest rates that recently exceeded 4.8% reflects what we think is the baseline going forward.
Using the model developed by Tobias Adrian, Richard K. Crump and Emanuel Moench at the Federal Reserve Bank of New York, the fitted yield for a 10-year Treasury bond now equals 4.95%. That figure reflects the sum of market expectations for the path of short-term interest rates (4.60%) plus a risk premium of 0.35%.
This the first time in years that the risk premium has been positive, which is an important signal that interest rates are indeed returning to normal.
Without further external events or domestic political instability, we can expect 10-year interest rates to remain in a range of 4.5% to 5.0% for as long as the market expects the Fed to hold its policy rate at 5.50%.
Recent events, though, threaten this stability. From the outbreak of war in the Middle East to a looming government shutdown in November, financial conditions remain at risk.
Already, rising real interest rates have pushed up the cost of commercial and industrial loans for middle market businesses, making it harder for these firms to meet payrolls and finance their expansion, according to a new survey from RSM US. Further shocks to the economy would only add to the strains they are already facing.
An appropriate long-term rate
Short-term interest rates were first sent to zero in 2009 and kept there because of the dire circumstances of the worst recession since the Great Depression.
The financial crisis and the simultaneous hollowing out of the U,S, industrial sector was followed by fiscal austerity, a slow economic recovery and the threat of deflation.
It fell on the monetary authorities to prevent further damage to the economy. Guidance from the Federal Reserve explicitly called for holding its policy rate at these low levels for as long as it took for the economy to recover.
With interest rates for all maturities compressed at the zero-bound, the risk of borrowing and lending plummeted.
All that worked to cause 10-year Treasury bonds to trade between 1.5% and 3% for nearly a decade.
As we’ve often reported, the time to borrow and to invest in the future was during this period. With interest rates so low, that meant that the cost of servicing that debt would be in deflated dollars even at the lowest levels of inflation.
Now, with the nominal 10-year rate pushing toward 5% and inflation easing to 3%, real interest rates are closer to 2%. As of Oct. 6, the rate on the benchmark 10-year Treasury Inflation-Protected Securities stood at 2.48%, significantly higher than 10 years ago.
What accounts for the reset?
The market has come to the realization that the Federal Reserve has revised its outlook for the economy, anticipating the stability of real GDP growth of 1.8% in the long term and inflation returning to tolerable levels.
Zero short-term interest rates are no longer appropriate, and the Fed is no longer buying fixed-income securities, known as quantitative easing, to pressure long-term interest rates lower.
The effect of this new normal can been seen in the calculation of long-term interest rates. The term premium associated with 10-year Treasury yields moved above zero in September, the first time since the pandemic shutdown.
According to the Adrian-Crump-Moench model, interest rates are determined as the sum of expectations for the path of short-term interest rates and the term premium, which is compensation for the risk that short-term rates might deviate from that path over the life of holding that security.
The path of short-term interest rates is important because of the direct relationship between long-term rates, which are the present value of purchasing a series of short-term securities.
While short-term money-market rates are usually immune to event risk, holding a bond for more than a month or two opens up the possibility of unforeseen events.
The term premium is the compensation required by investors to hold a Treasury bond over its maturity to protect against event risk.
In the Treasury market, event risk includes shocks like an oil shortage or a government impasse, exposing investors to the risk of everything from run-away inflation to a recession.
For instance, when the commodity markets crashed from 2014 to 2016, the term premium dropped below zero as the market weighed the probability of recession or depression.
Read more of RSM’s insights on the economy and the middle market.
The same holds for the anxiety that resulted in a negative term premium during the 2018-19 trade war and then into the pandemic.
The term premium became positive at the end of September. And now at 35 basis points, and with the market anticipating the path of short-term interest rates to remain at 4.60% over the life of the bond, the sum of the two components implies an appropriate 10-year interest rate of 4.9%.
The global market for Treasury bonds can never be fully modeled, and the 10-year bond traded tested 4.9% late last week.
Commentators have suggested that the recent glut of issuance following the debt ceiling standoff this year has pushed interest rates higher, even though the bid-to-cover ratio at Treasury auctions remains firm.
Regardless of day-to-day market responses, interest rates have been reset.
But first, another crisis
On Oct. 3, just as the yield on the benchmark 10-year Treasury was breaching 4.8% for the first time in 16 years, the House of Representatives was removing Kevin McCarthy from the speakership after he pushed through a 47-day continuing resolution to maintain government operations.
The turmoil has threatened the timely passage of 12 yearly appropriations bills that fund government operations, not to mention a bill to support the Ukraine military.
Facing another so-called fiscal cliff would increase the level of risk priced into financial assets and raise the cost of capital and credit for businesses in America’s real economy.
In addition, this latest political dysfunction risks a downgrade of the American credit rating, which would send yields higher.
As we show, the cost of corporate capital is highly correlated with the Treasury market and has risen to 6.6% for investment-grade bonds.
Another government shutdown
Although still early, financial conditions are deteriorating, with the surge in bond market volatility and the diminished performance of the stock market leading the way.
The RSM US Financial Conditions Index is a composite measure of risk priced into the money market, the equity market and the bond market.
As we show, the standoff over the debt ceiling earlier this year raised the level of risk in financial markets, only to return to normal as the standoff was resolved.
But the recent political turmoil in Congress has already pushed equity markets lower and gives global investors reason to think twice before investing in America.
Even without an increase in the federal funds rate, monetary conditions will tighten as lenders require additional compensation for the rising instability. That implies the likelihood of the Fed maintaining its policy rate at its current 5.5% until risk to the financial and economic outlook linked to the Congressional impasse abates.
Until that occurs, the risk of a further increase in rates remains a clear and present threat to the economic outlook.
