Source: wind
The Federal Reserve is raising interest rates rapidly to curb inflation, but in a world with bleak prospects for global economic growth, what should be a reasonable level of policy interest rates? This is one of the biggest concerns for investors right now.
After years of low nominal and negative real rates, markets are readjusting for an era of higher inflation. U.S. consumer price inflation moderated in April but remained near a high of 40, cementing the prospect that the Federal Reserve will continue to raise interest rates sharply.
After two rate hikes in March and May, the target range for the U.S. federal funds rate has been raised to 0.75%-1%. Federal Reserve Chairman Jerome Powell recently said a 50 basis point rate hike would be appropriate at both the next June and July meetings. Some policymakers prefer to assess the impact of policy tightening after interest rates reach neutral levels.
The Fed estimates that the “neutral rate” at which policy is neither too tight nor too loose is around 2.0% to 2.5%. What’s rattling the market is that high inflation will mean the Fed will need to raise interest rates above that level. Markets expect the federal funds rate to be as high as 3% by mid-2023 .
Kathy Jones, chief fixed-income investment strategist at Charles Schwab Research Center, recently noted that rising interest rates could eventually lead to a faltering economy, which typically triggers a sell-off in the most leveraged and weakest parts of the market. “(Markets) have shown signs of collapse since the Fed started signaling policy tightening at the December 2021 FOMC meeting. However, the economy has so far been resilient.”
Jones said that now that the nominal yield of US Treasury bonds has returned to the level before the outbreak of the new crown epidemic in 2018, most of the rise in yields in this cycle may have been completed. However, due to many factors affecting the market, it is difficult to determine the top of the cycle of interest rates. Therefore, other market indicators can be monitored to help confirm.
First, you can focus on the real rate of return. While nominal U.S. Treasury yields have rebounded sharply, inflation-adjusted real yields are only just entering positive territory after two years of negative territory, Jones said. The current real yield on the 10-year Treasury note is about 0.25%, about half of what it was when the Fed tried to normalize policy between mid-2013 and 2019.
She pointed out that the difference between nominal yields and inflation expectations determines real yields, and if inflation expectations fall, then real yields are likely to rise. In fact, inflation expectations reflected in the TIPS market have fallen sharply recently as markets begin to price in slower economic activity and inflation will persist for longer. The 10-year TIPS breakeven yield has retreated to about 2.7% from 3% touched last month.
Second, focus on the yield curve. In the past, when interest rates were at cyclical peaks, Treasury yields tended to converge, forming a flat curve, Jones said. The short end of the curve remains steep for now, but if the Fed raises rates quickly this year, as planned, the yield curve could flatten — often seen as a reliable indicator of rising recession risks, which could signal an imminent peak in rates.
Third, pay attention to credit spreads. Jones noted that credit spreads have started to rise, especially on riskier bonds. While the rise has only brought spreads back to their long-term averages, not yet at levels that suggest a significant increase in defaults in the corporate bond market, a surge in interest costs could weigh on the credit quality of the weakest bond issuers. Historically, high-yield spreads have risen the most late in the economic cycle.
Fourth, pay attention to the trend of the US dollar. In intraday trading on May 13, the U.S. dollar index once hit the 105 mark, continuing to hit a new high in nearly 20 years.
Jones said the dollar’s sharp rise in recent months reflects the strength of the U.S. economy relative to other major countries, widening interest rate spreads and some safe-haven buying from the volatile situation. A strong dollar tends to help dampen domestic inflation in the U.S., but because many commodities traded globally are denominated in dollars, a stronger dollar can reduce the purchasing power of other countries, causing inflation in those countries. She believes that the recent surge in the dollar may have reached the point of destabilizing some emerging market countries with large dollar debts. She noted that the Fed did not set a clear target level for the dollar, but did take into account the impact on the economy, which could prompt the Fed to pull back on its rate hike plans if the dollar continues to rise.
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