Andrew Baron, Butterfield
There are two forces holding down long-term interest rates in the U.S. currently, despite above-trend economic growth which might otherwise point to higher rates. The first is the U.S. Federal Reserve’s balance sheet expansion, or quantitative easing as it is known in the markets. The second is a pronounced slowdown in measured and expected inflation over the course of 2017.
In the aftermath of the credit crisis and deep recession, the Federal Reserve wound up setting short-term interest rates at zero in order to inject liquidity and stability to financial markets. In addition to setting short-term rates at zero for an extended period, the Fed embarked on another method of injecting money into the monetary system called quantitative easing. Quantitative easing, or “QE” for short, is a simple concept, if highly experimental and previously unprecedented. QE in practice is just the process of buying U.S. Treasuries and agency mortgage-backed securities, using the notional balance sheet of the Fed. As the central bank bought bonds from investors, those investors sought other uses for the capital they received from the sale of their securities. Economic theory holds that this activity should foster an environment of high liquidity, financial stability and low long-term interest rates.
In terms of scale, the Fed increased its balance sheet from roughly $900 billion dollars of securities to over $4.2 trillion, buying U.S. Treasuries and agency mortgage-backed securities over the span of the last 10 years. The Fed was actively buying new bonds to increase its balance sheet through 2013 and has, until very recently, held in place a policy to maintain the current balance of securities at its high level by reinvesting all maturities and principal repayments. The scale of this program, along with similar programs enacted around the rest of the developed market world, have boosted demand for “risk-free” assets and suppressed long-term interest rates.
On inflation, there is a pervasive line of thought within the Fed and among market participants that inflation is running consistently low (or too low). There is a “target” level, over the medium term, for inflation as measured by the core personal consumption deflator, or Core PCE, of 2 percent as set by the Fed. The 2 percent target has been implicitly set by Federal Reserve officials since the turn of the millennium and it has been explicitly stated in Fed communications since 2012. As we write, Core PCE is running at a 1.3 percent annualized pace, while overall CPI is running at 2.2 percent and Core CPI at 1.7 percent. Over the last 20 years, Core PCE has fluctuated in a range of 1 percent to 2.3 percent, with an average of 1.7 percent, so it is fair to say that for most of the tenure of the majority of people who work in today’s financial markets, the Fed has “missed” its inflation target. Indeed, if one looks at certain survey measures of inflation expectations, those too have fallen since the middle of 2014, although not precipitously. Low-realized and low-expected inflation has a tangible effect on interest rates, especially on longer-term interest rates, pushing them lower. After all, if inflation is expected to remain low 10 years from now, one only needs a certain premium over that inflation rate to be convinced to purchase a bond with a 10-year maturity.
The real question here is, “What happens to interest rates if these phenomena reverse?” Just as QE and balance sheet expansion on an unimaginable scale has had a downward effect on rates, should not balance sheet contraction push rates higher, all else being equal? This process is rapidly becoming a reality the market will have to deal with. In September 2017, the Federal Reserve announced that it would begin its program for the reduction of its balance sheet. While the reduction will begin extremely slowly and will only be reduced by slowing the pace at which maturities are reinvested, it is nonetheless a dramatic change. Thus far, as of this writing, the markets have taken this initial step in stride, but future reductions in central bank demand for Treasuries can provide the impetus for an upward bias in longer-term rates. Similarly, there is much complacency in markets as to the future rate of inflation. With job growth strong and the unemployment rate below what most economists consider full employment, there is extant danger that wages may begin to rise at a faster pace. These types of changes in the labor market happen slowly at first as the unemployment rate falls and then tend to gather pace more quickly than markets (or the Fed) expect, the closer the economy gets to full employment. If inflation expectations move higher, in conjunction with the Fed reducing its balance sheet and its role as the marginal buyer of U.S. Treasuries, it could be a recipe for a sharp reversal in longer-term interest rates.