By Mike Dolan
LONDON (Reuters) – A frantic recalibration of long-term borrowing rates has unnerved financial markets trying to parse both many of the positive reasons behind the move and worrying implications of a fresh hit to bond markets.
Almost independently of any new take on the trajectory of Federal Reserve policy – as the central bank is still not expected to hike rates again in this cycle – U.S. long-term bond yields have resumed a steep climb this month and have dragged interest-rate sensitive stocks lower into the bargain.
The simplest conclusion is the Fed will not be able to ease again in anything like the way many had assumed or still think.
Ten-year U.S. Treasury rates topped 4.3% this week for the first time since October, within a whisker of 15-year highs – sending real, inflation-adjusted equivalents close to 2% for the first time since the aftermath of the global bank bust in 2009.
The 30-year Treasury yield touched its highest in 12 years.
While Fitch’s Aug. 1 decision to remove the U.S. AAA credit rating may seem an obvious starting gun for renewed bond market jitters, most investors doubt this was more than a timing trigger.
More profoundly, the extraordinary performance of the U.S. economy – even after more than five percentage points of Fed rate hikes in under 18 months – has led many to examine whether the post-pandemic reshaping of economies is leading long-term sustainable interest rates back to pre-2008 crash levels.
Just this week alone, stellar retail sales, industrial output and housing starts numbers for July have forecasters scrambling to upgrade U.S. gross domestic product forecasts.
Having started the year with a consensus that Fed tightening would trigger recession within 12 months, U.S. growth actually accelerated to 2.4% annualised through the second quarter and the latest numbers suggest it could be even faster in Q3.
The Atlanta Fed’s, admittedly volatile, real time ‘GDPNow’ model is tracking a 5.8% rate for the current quarter, twice what it was a month ago and the fastest since January last year.
And Deutsche Bank (ETR:), one of the first to predict a U.S. recession would start as soon as this year, this week more than doubled its Q3 growth forecast to 3.1%.
With the labour market still near full employment, the prospect of rising U.S. trend growth is potentially hugely positive after 15 years of policymaker and investor handwringing over the dour after-effects of the Great Financial Crisis.
While that would inevitably mean high interest rates for longer and jibe with the backup in long yields underway, it should by itself be positive for corporate earnings potential and investment.
But there’s a more negative take. A rise in the theoretical long-term real interest rate that sustains both growth and stable 2% inflation – the fabled ‘R-star’ variable – may owe more to rising debt and more pernicious structural shifts.
While the Fed’s existing assumption is that R-star is still about 0.5% – implying a long-term policy rate of 2.5% if inflation returns to target – Vanguard economists estimate this week that it may well have risen as high as 1.5%.
“A higher neutral rate of interest in the U.S. will require the Federal Reserve to tighten monetary policy more aggressively than presently anticipated, potentially dampening the economic outlook in the short run and requiring a swift adjustment from private sector participants,” they concluded, adding aging demographics and rising fiscal deficits were the root cause.
‘DURATION CRISIS’
And rising deficits are cited by many as the key driver of resurgent yields in a period when the ‘free float’ of available bond supply is rising as central banks run down balance sheets – forcing the private sector to quickly absorb the resulting deluge of additional securities.
Anujeet Sareen, portfolio manager with Brandywine Global, reckons the fiscal supply picture was aggravated by this ongoing ‘quantitative tightening’ by G4 central banks and a reduction of Treasuries demand from emerging market central banks, due in part to geopolitics.
This will lift the ‘term premium’ embedded in long-term bond yields, which has been so subdued since Fed balance sheet expansion met the crash of 2008, even if the Fed is done tightening policy rates, he said. And 4.5% 10-year Treasury yields were possible.
Fed policy is more neutral than restrictive “if you believe we’ve returned to a pre-2008 world”, he said, and that limits the scope for rate cuts in future.
So much for the ‘bad’, but there is an ‘ugly’ too.
Liquidity specialists CrossBorderCapital claim this for now spells a crisis of the ‘safe asset’ bond world and not yet a credit crisis per se – but a ‘duration crisis’ could have big ramifications and Treasuries could test 5% as term premia were re-awakened.
If the value of these ‘safe assets’ falls more sharply and makes them riskier, they contend, then their use as collateral in amplifying credit and liquidity creation more widely via securities repurchase markets could be damaging for the credit system at large.
“If this is true, the entire base of the financial system and the trajectory of global liquidity are at risk,” they said, calculating that if inflation settles at 3% and the Fed neutral rate is still 0.5%, then a typical 150 basis point gap between long-term policy rates and the 10-year would imply 5% on the latter.
For BlackRock (NYSE:) credit analyst Amanda Lynam, some of this squeeze from higher cost of capital may already be underway for floating rate borrowers and fixed rate borrowers needing to refinance would not be immune.
“The higher cost of debt – which is flowing through to floating rate leveraged loan issuers in real time – is causing the leveraged loan default rate to notably outpace its high yield bond peer,” she noted.
“While the magnitude of this pattern is unusual in the context of the past two decades, we nonetheless expect it to continue, consistent with a persistent higher cost of capital environment.”
The opinions expressed here are those of the author, a columnist for Reuters.
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