The potential for rates to rise further

r* looks set to take off 

As the economic momentum continues apace and as inflation gathers further traction, the question of when interest rates will begin to rise in earnest is increasingly being asked. Over the last year, the yield on 10-year (10Y) US bond has risen from a 2017 low of 2.04% to 2.89% currently, while Bund yields have jumped from 16 basis points (bps) to 58bps over the same period.

Unprecedented monetary policy decisions and years of secular stagnation have together led to a fair amount of scepticism about when, or indeed if, interest rates will actually move higher. To assess this as objectively as possible, we have gone back fundamentals. This re-examination of how interest rates function leaves us with the expectation that 10Y US interest rates will rise to 4% by end-2020 and Bund yield to 2%.

Let’s look into the computations for the US, to explain how we arrived at this conclusion. We start from the well-known assumption that bond yields can be decomposed into expectations of the future path of monetary policy rates and the compensation that investors require for carrying uncertainty risk over monetary evolutions – what is referred to as the term premium.

For monetary policy rates, we use the r* framework (an unobservable variable, hence requiring a good chunk of judgement and modelling), which estimates policy rates from the output gap (the difference between observed growth and full-employment growth) and the distance between current inflation and the central bank’s target. We then enrich the model with the impact of post-crisis regulation and leverage. This gives us a US r* estimate (or equilibrium real short-term interest rate), which we see slowly rising to 1.25% by 2020.

For long-dated interest rates, we add the effect of the end of quantitative easing (QE) – about 40bps – to rising monetary policy uncertainty as we move in the future, which we estimate adds 60bp to the current term premium. Taking into account inflation expectations, this moves the US 10Y yield towards 4% by 2020. Assuming the US deficit rises to around 5% of GDP and remains there until 2020, this could add another 30bps.

Where does that leave us? Three main considerations

First, our expectation that interest rates could rise towards 4% by 2020 reflects the robust economic momentum that has finally lifted the spectre of eternally low inflation, allowing monetary policy to leave the centre stage. This momentum will likely persist in the US, as survey evidence has gone from strength to strength with most recent ISM surveys posting highs not seen since 2004. Similarly, across the Atlantic, economic surveys support our forecast for above-consensus Eurozone GDP growth, at 2.7% in 2018. And, as expected given forecasters’ behaviour during previous expansion phases, consensus (now at 2.3%) seems to be progressively catching up. Inflation should slowly climb towards 2% in 2019 in the Eurozone, but be more than 2% in the US.

Second, risks are probably more palpable than before the financial crisis. For a start, inflation, if it were to accelerate, possibly supported by trade tariffs, will put unforeseen upward pressure on interest rates. Notwithstanding the fact that at his most recent press conference, European Central Bank (ECB) President Mario Draghi delivered a master class in communication with the markets. It resulted in only a shrug confirmation of the ongoing monetary policy normalisation, and that receding central bank demand for bonds may lead to a rebalancing of supply and demand, which would add further pressure to rates, especially in the US. Add to these political risks from the Italian peninsula, geopolitics in Asia and the Middle-East – that we are not able to price –, and the potential for disruption of this “perfect” outlook is relatively elevated… and unpriced.

Finally, looking ahead, we remain wary of the possibility of a “new normal” outcome – a world in which interest rates, even if they are rising, are still below their pre-crisis level, while debt levels are more elevated and the fiscal space to address a slowdown is narrow. The US’s debt-to-GDP ratio should be north of 100% this year, while the Eurozone’s ratio should be about 90% on average, according to the International Monetary Fund (IMF) estimates. Although we could argue this is especially true for the Eurozone where France and Germany struggle to agree on how to use monetary and fiscal policy in a downturn, it is also true in the US where the current administration has sent conflicting signals regarding Fed independence.

Let’s just hope the cycle will age gracefully, undisturbed by political noise.

No change to our pro-growth tilt

Against this backdrop, our asset allocation reflects continued growth momentum, our expectations of slowly rising rates and unpriced uncertainty. We remain overweight growth-sensitive assets (equities, high yield and emerging market debt), with some qualifications. Hence, for equities, although we have closed our US position, post February’s volatility episode, we tactically increased our equity exposure position, which paid off well. We remain overweight especially in European banks and emerging markets.

With long-term interest rates having risen about 30-40bps since December, we have had a good run. It is therefore possible that markets consolidate at current levels (or even slightly lower) over the near term. Still, we see asymmetric risks in holding duration and our alternative scenarios are tilted towards a sharper correction. As a result, we maintain our structural short bias on duration.

Regarding credit, we foresee a mild spread widening over the coming months. With long-term US interest rates about 75bps above their three-year average, they are nearing a level where credit spreads could be hurt by rising interest rates. Hence, we expect to see a continuation of the reflation dynamic that results in high yield outperforming investment grade debt, but the outright direction of total returns is set to be swayed by moves in underlying interest rates. 

Given our macro outlook has not changed and in the absence of special events, we have made no change to our FX views and hold a positive bias on the Japanese yen and the euro. We keep our target for year-end at 1.28 for EUR/USD.

Download the full slide deck of our March Investment Strategy

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