Borrowers should prepare for a significant shift in the global interest rate environment in the next few years, Fitch Ratings says. Fitch expects US real interest rates to increase to levels that are more closely aligned with US economic growth potential.
“With the Fed having now achieved its inflation and employment objectives, becoming more focussed on the risk of labour market tightening and starting to discuss the unwinding of its balance sheet, we expect interest rate normalisation will take place by 2020 and that the Fed Funds rate will reach 3.5% to 4%,” said Brian Coulton, Chief Economist at Fitch.
This estimate is above the Fed’s current “DOTS” projection for the long term and substantially higher than current financial market expectations for US rates in three years’ time. It would also imply a sizeable upward shift in bond yields to the 4% to 5% range as long-term expectations for the Fed Funds rate adjust.
The fall in US real interest rates (i.e. nominal rates adjusted for inflation) has been one of the most striking macroeconomic trends over the last decade or so and has gone well beyond what can reasonably be explained by shifts in economic growth or inflation performance.
One school of thought puts this shift down to long-term fundamental changes in the real economy that have boosted the supply of savings at the same time as the demand for funds for investment has diminished. Demographic changes, rising inequality and an emerging market (EM) savings glut are claimed to have pushed out the supply of savings, while lower public investment, falling capital goods prices and an increase in the risk premiums required for private investment projects are seen as having driven down investment demand. The fall in real rates is seen as a lasting shift to a new ‘equilibrium’, where the relative price of savings is permanently lower and real interest rates are unlikely to rise much above zero per cent even over the medium to long term. This view appears consistent with market expectations that the nominal Fed Funds rate will not increase much beyond 2% – i.e. in line with the Fed’s inflation target – even by 2020.
However in Fitch’s view, this conclusion does not look robust. US saving rates actually fell as the working age share of the population increased after 2000 and Fitch’s calculations suggest that the increasing share of the top quintile in total household income (a group which has higher saving rates than average) is unlikely to have significantly raised the aggregate saving ratio. Financial linkages between the US and EM are weaker than those with other advanced countries and EM current account surpluses and FX reserve accumulation have fallen since 2014 without prompting a correction in US real rates. Public investment has fallen to historical lows but there could be upward pressure over the medium term. The relative price of capital goods has been broadly stable since the mid-2000s. Finally, rising risk premiums can just as easily be explained by distortions to government borrowing rates from central bank Quantitative Easing polices as by increased hurdle rates for private investors.
An alternative view sees current exceptionally low real rates as the outcome of an elongated credit cycle whereby commercial bank and central bank actions have driven real rates away from equilibrium for an extended period. The narrative that accompanies this view highlights loose monetary conditions in the US in the early to mid-2000s, which set the scene for aggressive credit creation and risk pricing by commercial banks. These conditions contributed to the sub-prime crisis, which then saw central banks loosen monetary policy aggressively to minimise the impact of the crisis on the real economy. This view implies that real rates will revert to more normal levels – more closely aligned with economic growth – once the credit cycle has played out. Fitch sees considerable intuitive appeal in this characterisation.
A crucial question is where the economy lies in the current credit cycle. This boils down to the capacity of the US economic recovery to withstand higher interest rates. Aggregate macroeconomic data on debt burdens suggest that it can. The US household debt to income ratio has fallen to early 2000s levels, household debt service ratios are at record lows and the interest-coverage ratio for the US corporate sector in aggregate is at a multi-decade high.
“If the credit cycle view of US real rates is correct and if the cycle is nearly over, the implication is that nominal US interest rates will adjust quite sharply in the next few years,” added Coulton.
Fitch’s assessment of US potential real GDP growth is around 2%, which would imply a real Fed Funds rate of 2% or slightly below. Given the Fed’s inflation target of 2%, this would imply a nominal Fed Funds rate of 3.5% to 4.0% once the current cycle has ended and rates have normalised.