Where should interest rates be? This has been pondered countless times over the last decade as the Fed imposed a monetary policy of extreme easing during the depths of the Great Recession, keeping interest rates near zero in subsequent years, before their the normalization process of raising them more recently. It’s important to keep in mind that the Fed only directly controls one key interest rate—the fed funds target. This is the interest rate financial institutions use in lending to each other—which serves as an important starting point for market rates on short-term treasury bills, money market funds and bank deposits. Long-term rates, however, while loosely anchored to short interest rates, are driven much more by future inflation expectations.
While all other non-fed funds interest rates are market driven, there are some historical patterns that could be helpful in anticipating a ‘fair value’ across the yield curve. It’s perhaps most helpful to look at this from a building block perspective, in which the total nominal interest rate is decomposed by its component parts. Then, the parts are unassembled, estimated and reassembled, to see what a realistic fair value could look like. Although, as with stocks, this exact point is never agreed upon so it exists mainly in theory.
The ‘Real Rate’
The first building block is the ‘real rate’, which represents the yield earned for an investor taking on the risk and opportunity cost of lending money in the first place. While U.S. treasuries are considered ‘risk-free’ by most investors (at least free from default), that probability, while small, isn’t zero. The real rate also includes compensation for other uncertainties, such as volatility of future inflation and bank policy (and why real rates for emerging market nations tend to stay so high). Longer-term interest rates also usually contain a ‘term premium’, which is a rate spread that compensates bond owners for taking on the uncertainty of being locked into a longer maturity versus a shorter one. Lastly, expected inflation itself is added in, as bond owners expect to be paid for the loss of purchasing power during the life of their investment.
This gets us to the following relationships. (Note that corporates and other bonds considered as ‘credit’ also contain the building block of a credit spread in addition to these base rates—compensating investors for the risk of default.)
Short-term rate = Real rate + Inflation
Long-term rate = Real rate + Term premium + Inflation
The ‘Dot Plot’
The Fed’s own ‘dot plot’ and Wall Street fed funds rate projections over the next several years fall around a midpoint of 3.0%. Considering the Fed’s inflation target is 2%, this implies a real rate of 1%. Term premium has varied dramatically over time, but the presence of a flattening yield curve implies that it’s trending tighter, which is typical of later in the economic cycle—now just under 1% (since the early 1980’s, it’s ranged from an inverted -1% to a very steep 4%).
Per Fed Chair Powell’s recent comments, market participants are concerned the Fed may go beyond ‘normal’ to as a far as 3.5% or higher. As much as anything else, this added chance of an overshoot has enhanced recent interest rate uncertainty. While rates matter not only for bond prices directly, and economic borrowing activity, they are also an important input to valuation models (when rates move up, asset/entity fair values move lower).
There are no shortage of predictions about the future direction of rates. On the more bullish side calling for higher rate levels, economists point to pent-up inflation—notably from strong labor markets and need for higher worker wages, as well as strong monetary stimulus of the last decade and higher oil prices. This is in addition to the inflationary impact from tariffs, should a broader trade war come to pass. Rates should technically rise in keeping with a nation’s rising budget deficits and deteriorating debt-to-GDP ratio, since higher ‘credit risk’ is implied.
On the other hand, the current rate level remains higher than that of all other developed nations that are usually the top competitors for safe assets during periods of equity market volatility, including the U.K., Europe and Japan. This high demand for yield globally has kept U.S. rates down, as has the Fed’s QE bond-buying activity (which is being now unwound). Bearish economists point to a lack of pent-up inflation, due to weaker long-term economic growth forces, such as aging demographics and low productivity, in addition to more widespread deflationary forces that have pushed down the prices of technology and other consumer items. Historically, periods of deflation and lower growth have tended to put a lid on rates, sometimes for extended periods.