HSBC's Major said the bigger picture is still one of “lower for longer” on policy and yields, even if a return to quantitative easing or the “zero lower bound” is highly unlikely. — Reuters
IF you think this time is different, and the post-2008 world of low interest rates and bond yields is over, think again.
Markets may have spent the last two years grappling with the highest inflation and rates in decades, unleashed by the pandemic and Russia’s invasion of Ukraine, but the underlying picture is remarkably stable.
So said Steven Major, HSBC’s head of rates strategy, who famously swam against the tide for years and correctly called the extension of the US and global bond bull market and persistently low interest rates and bond yields.
After a bruising few years – Treasuries could be about to register their first rolling three-year period of losses since the foundation of the US Republic, according to Bank of America – Major is still swimming against the tide.
In a nod to the Federal Reserve’s (Fed) current “higher for longer” rates stance, Major said the bigger picture is still one of “lower for longer” on policy and yields, even if a return to quantitative easing or the “zero lower bound” is highly unlikely.
What’s more, Fed officials’ longer-term rate projections and New York Fed model estimates of the theoretical long-run equilibrium interest rate – or “R-Star” – suggest policymakers probably agree.
“’Lower for longer’ is not some contrarian meme. It could be used as a framework, a description of what has happened, or a policy statement of forward guidance.
“It very much applies to China today, has previously applied to Japan and the United States in the past, and might still in the coming year,” Major said.
The New York Fed on Tuesday lowered its latest estimates of “R-Star”, the neutral interest rate that neither stimulates or restricts economic activity.
The bank reduced its closely-watched estimate of R-Star to 0.57% in the second quarter from 0.68% in the first. That’s the lowest since 2014 and sharply down from the recent peak of 1.32% at the end of 2021.
Assuming inflation returns to the Fed’s 2% target in time, R-Star implies a long run nominal federal funds rate of just over 2.5%.
That is exactly where Fed policymakers’ median interest rate projection has been since June 2019, barring a dip to 2.4% early last year.
The Fed’s persistently low long-term rate outlook and New York Fed’s declining R-Star estimates despite the highest inflation, policy rate and bond yields in years, suggest rates and yields won’t stay this high for long.
With the fed funds target range currently 5.25%-5.50%, Fed policy is extremely restrictive, by around 250 basis points or more.
A Dallas Fed paper in July found that policy has been restrictive since the first quarter of this year.
Debt overhang
Central to Major’s long-term outlook is something that most economists and policymakers agree is unwelcome and poses increasing risk, but for different reasons: debt.
Ballooning debt is usually seen as a trigger for higher borrowing costs as lenders demand more compensation for the perceived higher risk that they might not get paid back, and the risk that interest rates will fluctuate over the life of the bond. Credit risk and the so-called “term premium”.
But Major argues this applies to “productive” debt, borrowing that increases productivity in the economy, leading to faster, stronger growth and hotter inflation.
The artificial intelligence explosion may be the catalyst for that secular surge in productivity, but it is too early to say.
Other tech-related advances in recent decades like the Internet and smart phones have been heralded as productivity game-changers, but have really turned out to be false dawns.
Granted, this borrowing may spur consumption, infrastructure investment, and even growth in the very short term, but doesn’t necessarily boost trend or potential gross domestic product growth.
Huge “unproductive” debt can be a powerful force depressing yields and growth.
On top of that, other trends that have pushed rates and yields lower in recent decades – ageing populations, rising inequality, too much savings relative to too little investment – are still largely in place.
In that world, with the economy set to slow as the full effect of previous rate hikes kicks in, why would investors not buy Treasury bonds to secure a guaranteed stream of regular coupon payments and a yield of between 4% and 5%?
The Fed publishes its updated inflation, growth and policy rate outlook on September 20 in the latest Staff Economic Projections. Investors may have a clearer signal then. — Reuters
Jamie McGeever is a columnist for Reuters. The views expressed here are the writer’s own.
