Home > Library > Stable Times > Volume 8, Issue 2 & 3  

US Rates: A Cycle Like No Other

Where are US rates going? The potential for mispricing in the curve is probably greater than at any time since the development of the Eurodollar market began, forty-odd years ago. Why? Because there is a chance that the prevailing economic orthodoxy -- which says we are in a "normal" US cycle -- is simply wrong. That orthodoxy says, in effect, that once a recovery clearly gets going, it continues until the central bank has to step in to slow things down. Because there are lags in the effect of monetary policy, then once a recovery is firmly established, the central bank will typically wish to get short to a "neutral" level perhaps a year or so before the expected return of the economy to full capacity-utilization - a zero output gap. However, this cycle is likely to be different, and, as a result, the Federal Reserve may not raise rates as much as the Eurodollar contracts are predicting. In fact, the Federal Reserve might be forced to stop tightening monetary policy after only a handful of rate hikes.

Until a few months ago the Fed was apparently not convinced that downside risks had been eliminated. But as soon as Greenspan said, in late April, that deflation was now definitely no longer a danger the market reacted violently. After the Greenspan comments, a high CPI number and a change in language in the FOMC statement, the market is now (late-May) pricing short rates for mid-2005 to reach 3½ percent and those for mid-2006 to reach 4½ percent. Ten-year yields, which in late-March were about 3¾ percent, are now (late-July) around 4.8 percent.

It is striking to compare the current expectations for 3-month eurodollar rates with what actually happened in the hiking cycle that began in 1994. Then, 3-month rates doubled during the course of the year, going from 3.15 percent in January 1994 to 6.27 percent in December (month averages). That was a much faster increase than is currently priced in by the curve. But rates subsequently drifted down a bit, and by February 1997 3-month rates were at 5.63 percent, about 250 bp higher than before the cycle began. In contrast, the curve currently depicts 3-month rates rising monotonically for several years, reaching a level around 6 percent later in the decade.

Is this path of short rates plausible? It seem to imply that inflation gets - even if gradually - quite a way above current underlying levels (according to the Fed, the underlying trend rate of inflation is currently about 1½ percent). The market is apparently suggesting that the Fed is, and will remain, behind the curve and that it will not act vigorously enough, soon enough, to head off a significant rise in underlying inflation. (The breakeven inflation rate implied by longer-term TIPS yields also apparently suggests expectations of a trend inflation rate above the Fed's "comfort" range).

Does that mean that in order to avoid a rise in inflation the Fed should act in a way that pushes 3-month rates up as sharply as in 1994? If the Fed has been wrong about the size of the output gap or its relevance to inflation, then there is an argument for an upward jump, that is, more or less immediately, to a level of 4½ percent or even a bit higher. But there are two reasons for thinking that would be very dangerous.

First, the currently-implied expected short rates several years out are just an interpolation from long rates - and violent swings in long rate are mainly the result of positioning panics and risk reduction in the market. If short rates now "jumped" upwards, then that would not produce a flattening in the curve and a reduction in apparent future inflation expectations but another lurch upwards in long rates. That would in turn indicate, to those who believed in the inflation-prediction power of the curve, even higher expectations of future inflation. But if the Fed responded with another upward "jump" in short rates, long rates could well go higher still. In short, it is almost certainly wrong to see the curve as a meaningful indicator of future inflation expectations.

Second, it is highly likely that even the current height of the curve will be too much for the US recovery to be sustained. That is, the current economic orthodoxy is wrong and the recovery is definitely not a "normal" one. Comparisons with the cycle of the early 1990s are very telling. That cycle was a "normal" one. Sharp increases in interest rates between the Spring of 1988 and the Spring of 1989 set the scene for falling household demand in 1990/91, a fall exacerbated by rising oil prices and reduced consumer confidence around the time of the Iraqi invasion of Kuwait. Residential construction and spending on consumer durables fell very sharply, and as growth slowed and profit margins dipped, accelerator mechanisms then depressed business investment, too. All these elements of spending fell below "normal" levels, and when the Fed took fright at the extent and persistence of recession, it needed very low levels of interest rates to begin stimulating spending again. When that process was sufficiently well-established, the momentum of pent-up big-ticket household spending was strong enough for the Fed to be able to begin, in February 1994, moving rates quite quickly back to "normal" levels without crushing growth.

What is remarkable about the current cycle, in contrast, is the extent to which the Fed has had to keep household spending unusually strong almost throughout the period since business confidence collapsed in the second half of 2000.

There is certainly now no "pent-up demand" for houses or consumer durables - indeed, spending in both areas is already showing signs of slowing quite sharply. Rising interest rates now, combined with the disappearance of the stimulus from tax refunds and with the appearance of a new "oil tax," are likely to exacerbate the slowdown in household big-ticket spending and turn it into a period of sharp absolute falls. And the unusually favourable conditions for business investment this year -bunching of delayed replacement investment held back from the financially-constrained 2001-2003 period; unusually high profit margins as productivity accelerated unexpectedly ahead of wages growth; the bringing-forward of investment from 2005 to take advantage of the temporary partial expensing tax provisions; unsustainably rapid growth in Chinese demand -will no longer obtain next year. So the removal of the very important prop represented by extremely low ex ante real long rates of interest is likely to mean that 2005 will be a weaker year for business investment, too. In all, 2005 is likely to be a "payback" year - one in which over-investment by households in houses and durables as a result of extremely low interest rates leads to a period of significant retrenchment, however robust household balance sheets might appear to be.

Give all that, unless the US economy is supported by massively higher net exports - and that would require a dollar depreciation far bigger than the rest of the world could absorb -- it seems simply inconceivable that short rates can go on rising through 2005. In fact, it will be very surprising if short rates get much above two percent before the Fed has to do a handbrake turn and start bringing rates down again.

AIG Financial Products Corp. is not and does not purport to be an adviser as to legal, taxation, accounting, regulatory or financial matters in any jurisdiction. Readers should make an independent evaluation and judgment with respect to the matters referred to herein.

Read Next: Editor's Corner - Stable Value Cash Flow - What Really Matters?