The danger in the US is not rising interest rates themselves, but rises that surprise
US President Donald Trump, being the businessman he was (or is), woke up one recent morning worrying about interest rates and what the Fed might do to the US economy (or perhaps his real estate portfolio) with higher interest rates.
Being Trump, he immediately Tweeted his concerns to the world at large, so defying the convention that the Fed should be independent of political forces, causing predictable consternation. But with more reflection he might have noticed that the market place was doing the job for him: of actively restraining the upward march of interest rates expected in the future.
While short term rates, under the direct influence of the Fed, have been on the rise and are confidently expected to rise further over the next 12 months, the pace of further increases is expected to slow down to very gradual increases over the next three years. The current yield on a one-year US Treasury Bond is 2.42%. In a year’s time this yield is expected to be 2.87% but in three years’ time it is expected to be only a little higher, at 2.94%.
One can interpolate the expected rate of interest from the term structure of interest rates. Investing in a one year to maturity Treasury will yield 2.42%. A Treasury Bond with two years to run now offers little more, or 2.64%, and a three year Treasury Bond yields but 2.73%. An investor can secure 2.73% by committing to a three year investment, or alternatively invest for a year at 2.42% and then reinvest for a further year at what will be the one year rate in a year. The expected returns must therefore be very similar given the alternatives of investing for longer or shorter periods.
Given the alternative of investing for a longer period or a shorter period and then reinvesting the proceeds, the longer-term rates can be regarded as the (geometric – allowing for compounding of interest) average of the expected short term rates. The difference between the fixed yield on a two year bond and the fixed yield on a three year bond can be used to calculate the one year rate expected in three years’ time and so on for any one year period in the future. We have reported these expected one year rates above from a table provided by Bloomberg (The US Treasury Active Curve).
Thus the steeper the yield curve – the greater the difference between long and short term – the more short rates must be expected to rise. The flatter the yield curve – the smaller the difference between long and short rates – the smaller must be the expected increase in short rates. Should the yield curve turn negative, that is when short rates are above longer term rates, this means that short rates must be expected to decline in the future to provide average returns in line with the currently lower longer-term fixed rates.
Borrowers typically incur debts with extended repayment terms. So what is expected of interest rates (more than current interest rates) will influence current decisions to borrow and to spend. Such modest increases in the expected cost of servicing debts in the US is unlikely to be a deterrent to current borrowing and lending decisions undertaken by firms, households and banks or other suppliers of credit.
In the US, the gap between longer and shorter term interest has been narrowing sharply as we show below. Short-term rates have been rising much faster than long term rates – the yield curve has therefore flattened – giving rise to very modest further expected increases in short-term rates reported upon earlier. The difference between the fixed yield on a 10-year US Treasury Bond (2.93%) and a two-year bond (2.64%) is currently a mere 27 basis points (0.27 of a percentage point). The extra rewards for investing currently at a fixed rate for 30 years in a US Treasury Bond (3.05%) rather than 10 years is therefore a very scant 12 basis points. Clearly this reflects a very flat yield curve beyond two years and very limited expected increases in interest rates to come.
We therefore need to consider the causes as well as the effects of rising or falling interest rates. Short-term rates can be expected to rise with economic strength and the upswings in the business cycle and fall as economic activity slows down. A sharply positive yield curve implies faster growth and higher interest rates expected. And these higher interest rates can then be expected to slow down the pace of economic growth, hopefully to a rate of growth that can be sustained over the long term. A flat or negative yield implies slower growth to come and in turn lower interest rates to come; that is to help stimulate economic activity enough to enable the economy realise its long term growth potential without deflationary pressures.
The flattening of the US yield curve, while encouraging current spending by restraining the expected cost of debt service, may portend slower growth to come and therefore less reason for the Fed to raise short-term rates in the future and so act as the market expects it to act.
The danger to the US economy however does not come from higher or lower interest rates – provided that they behave as expected – and so move consistently with the expected state of the economy. If this were to happen, interest rates would have little real effect on borrowing, lending, spending and the economy. The danger is therefore not that interest rates may rise, but rather that they rise unexpectedly rapidly. This would disturb the economy and slow down growth unnecessarily rapidly. Trump might have noticed just how carefully the Fed has been to make its actions as predictable as possible, so aligning actual and expected interest rates. His and our concern as economy watchers should be about the danger of interest rate surprises – not interest rate levels. 26 July 2018