By Yoruk Bahceli
(Reuters) – Accumulating bets on higher interest rates did nothing to derail a stock market rally based on the conviction that policy tightening by the US Federal Reserve and other central banks won’t come close to what it has been in the past.
A new bout of COVID-related uncertainty has dragged markets back a bit from the massive interest rate increases priced next year from the Federal Reserve, the Bank of England and others. But Federal Reserve Chairman Jerome Powell’s latest comments suggest he is on track to raise interest rates several times in the next two years.
Stock markets have been mostly unfazed by talk of rising interest rates — equity funds have had inflows every week this year, except for two. Investors say in a world where bonds, based on inflation, yield well below 0%, there is simply no alternative.
And those negative “real” yields, along with persistently low long-running government borrowing costs, flattening yield curves and higher equity, all depend on the view that eventual interest rates — or where central bank policy rates peak — will be lower than they were It was in previous sessions.
The Fed’s previous rate-raising cycle peaked at 2.25%-2.5% in 2018. But the next cycle will end below 2%, according to the EURUSD futures view of US rates in five years, a proxy for the final interest rate.
That bet, which is less than the 2.5% forecast by the Fed itself, reflects the belief that policy tightening may end before interest rates reach the Fed’s 2% inflation target. This means that “real” US interest rates will remain negative.
It’s a similar picture in the Eurozone and Britain, where final interest rates are seen just above 0% and just below 1%, respectively.
“What the stock markets are saying is…interest rates are not going to go very high and real yields will remain low,” said Craig Inches, head of interest rates and liquidity at Royal London Asset Management.
“Bond markets are saying…we’ll keep long-term yields low because we think (prices) will go up, and then go down again right away.”
But there is no margin for error.
$1 trillion has been poured into global equities this year — more than the previous 19 years combined — pushing stock price valuations to new highs. Corporate bond risk premium is historically low, while cumulative household, corporate and sovereign debt has jumped $36 trillion during the pandemic.
For this reason, many believe that real US yields – currently less than 1% on the 10-year benchmark – will need to stay below zero for years, if not decades. Yields remain stubbornly low on long-term bonds – 10-year Treasuries have peaked at just under 1.8% this year.
“What is driving the longer part of the curve is the expectation that once central banks start raising interest rates, they will not be able to get anywhere near the levels they reached in cycles,” said Barnaby Martin, head of credit strategy at Bank of America (BofA). previous hikes. .
The natural or neutral rate is crucial to estimating the final rate, sometimes called r-star – the level of price equilibrium where full employment coexists with stable inflation.
This rate has been steadily declining throughout the developed world. Causes range from an aging population to high savings rates and the United States is no exception, with the adjusted inflation rate dropping to about 0.4% last year, from 2.5% in 2007.
Risk neutral rates turn higher than draft markets.
Some argue that long bond yields, suppressed by massive demand for safe-haven securities, are a misleading indicator.
Second, early and fresh rate increases compared to the Fed’s expectations indicate that investors are not buying the Fed’s shift to flexible average inflation targeting (FAIT). With FAIT, the Fed aims for inflation to average 2% over time and will tolerate temporary excesses.
Jonette Dengra, head of US interest rate strategy at Morgan Stanley, indicated that the Fed was aiming to raise the neutral rate when it launched its new inflation strategy.
“To the extent that you can call the FAIT a success, you can also say the Fed has succeeded in raising the neutral rate higher than the previous cycle,” Dingra said, predicting the final interest rate would come in at well over 2.5%.
Rates can also be raised through increased corporate spending, improved productivity and, above all, labor market changes. Here, economists will be watching the NAIRU – the lowest unemployment rate that can continue without increasing inflation.
The question is whether the pandemic will reverse NAIRU’s years-long slide, if for example workers get more bargaining power in wages.
There is no sign yet of a wage vortex, although the current labor shortage means final market price bets may be challenged.
And if the shortage eases, it could increase the likelihood that the Fed will stick to the cycle of interest rate hikes it currently expects.
Ludovic Collin, portfolio manager at Vontobel Asset Management, says “violent” repricing of long bonds is a risk.
“For stocks to maintain the current valuation they have, that would be a very tightrope for them to walk.”
(Additional reporting by Yoruk Bahceli Additional reporting by Sujata Rao; Editing by Sujata Rao and Mark Potter)