Interest rates may be structurally higher in the future

BoE member Megan Greene warned that rates may be structurally higher in the future than they have been in the past.

The interest rates in developed countries could be higher in coming years, even coming decades, than they have been in recent decades. However, even the structural bears of the bond market have to accept that a significant cyclical decline in yields is likely first.

We have long argued, even before Covid, that the world was likely to enter a long-term period of higher inflation and higher rates. We ascribed this to what we’ve called, the three “Ds”: demographics, deglobalisation and de-dollarisation. The first of these involves sharp increases in dependency ratios in developed (and many developing) nations as the number of elderly increases relative to the number of working-age people. This trend causes demand to rise relative to supply, lifting inflation, and savings to fall relative to investment, which also lifts rates.

Second, deglobalisation adds to the inflation and interest rate pressures as firms shift, or even reshore, supply chains to counter economic and geopolitical strains.

Third, de-dollarisation can potentially add another layer of rate pressure if it forces the US to have to offer higher rates in order to attract the levels of financing required to fund the large budget and current account deficits.

Recently, we’ve heard from new BoE member Megan Greene, who this week warned that rates may be structurally higher in the future than they have been in the past. In the US, former Fed member Bill Dudley has caused a bit of a stir by making similar arguments and arguing that 10-year yields could rise to 4.5%.

But in spite of the view that rates will be structurally higher in the future than the past, Mr. Steve Barrow, Head of Standard Bank G10 Strategy still looks for the Fed and others to cut rates sharply next year and for bond yields to fall significantly (especially at the front end of course). Aren’t these two things contradictory?

If we start with the bond market, in spite of any arguments about higher structural rates, cyclical factors will lower yields considerably. In short, bond market investors seem likely to ignore these structural arguments and will pile into the bond market in exactly the same way as they would have done in the past as the policy cycle changes. The result of this is that 10-year treasury yields appear more likely to be driven, in a cyclical way, to 2% over the next year, or so, even if a more ‘appropriate’ level in the long-term is closer to the 4.5% that Bill Dudley talks about.

What about central banks such as the Fed? Will they recognise that things have changed and policy rates should not be cut as significantly even if economies tip into recession and inflation falls materially? If we look at the median FOMC forecast from the last meeting, it posits just over 200-bps of rate cuts between the end of 2023 and 2025.

But in Mr. Steve Barrow’s view, if bond yields are falling swiftly – as the market anticipates policy easing – the Fed is likely to cut rates by more than its own median forecast of just over 200-bps and so help to justify the ongoing fall in bond yields. In other words, policy rates and bond yields will cyclically overshoot to the downside for a period of time before returning to the structurally higher levels necessary for a world in which the three “Ds” and other factors imply higher rates than we’ve seen previously, not the same – or lower - rates. For while those such as Greene and Dudley might be correct on the structural direction for rates they probably underestimate the hysteresis that exists within investors, and probably within central banks as well.