US – Markets misjudge interest rate risk

How weak is the economy really?

The economic outlook is the dominant driver of interest rate markets. How pronounced will the economic slowdown be, how will political trouble spots evolve and will they inflict further damage? Recent economic data were mixed. A period of weaker growth is on the horizon, but there are no indications of a severe slump. Markets are betting on negative scenario though: a US rate cut is expected before the end of the year and yields on 10-year German Bunds have dropped below zero.

We expect that the economy will stabilize, a prospective outcome that will make it impossible to justify recent market valuations. However, the risks this forecast entails are substantial - not least because they are political in nature, which makes them hard to predict. Ultimately no country can be bent on torpedoing foreign trade though; it seems to us that the most likely scenario will therefore involve solutions, once one gets tired of issuing threats and/or being impeded by domestic political infights.

In addition to our assessment of monetary policy in the euro zone and the US and the associated government bond markets, this issue of the Interest Rate Outlook includes the first part of a series of analyses of megatrends we expect to emerge in the coming decade. We begin by discussing the implications of climate change and the fight against it. There is a chance that the long overdue changeover to a carbon-free economy will be implemented, and the impact will be profound.

 

Monetary policy

Euro Zone – rate hike not on the horizon

As a result of the economic slowdown in the euro zone since the second half of 2018, attainment of the ECB's inflation objective has receded even further into the future. The central bank has accordingly postponed the earliest possible date for an initial rate hike from September of this year to January of next year. Administered interest rates will therefore remain unchanged for the foreseeable future.

The markets are nevertheless waiting for two ECB decisions over the coming months. In June, or in July at the latest, the central bank will announce the hitherto unavailable specifications of its TLTRO-3 program. What is so far certain is that quarterly targeted refinancing operations will be conducted from September of this year until March 2021. The loans will have a term to maturity of two years each. What is yet to be decided is how the interest rate will be determined and how much money banks will be able to take up. The only information released so far is that the interest rate will be indexed to the main refinancing rate and that the volume will amount to up to 30% of the stock of eligible loans. What the stock of eligible loans will consist of has not been decided yet. The design of these specifications is inter alia going to be tied to the performance of the economy. We expect that the interest rate will be low and include discounts to the main refinancing rate tied to lending growth at the banks concerned. It seems likely that the definition of the stock of "eligible loans" will be relatively broad, as the central bank will probably not want to appear hesitant.

While there will definitely be a decision on the terms of TLTRO-3, there is only the possibility of a decision with respect to the second issue. In recent months ECB representatives have frequently addressed the fact that the negative deposit facility rate is weighing on bank profitability and potentially on the extension of loans. However, the ECB has so far not communicated a clear policy line on the matter. One approach would consist of adopting a two-tier deposit facility rate system such as in Switzerland. In that case banks would have to pay less or even nothing for part of their deposited reserves. At the same time the ECB would have to ensure that this doesn't trigger an increase in money market rates, which are aligned with the deposit facility rate. A two-tier rate could meet these requirements. Nonetheless we give its implementation a chance of not more than 50 percent.

There are currently no signs of movement in the interest rate landscape beyond the debate over the deposit facility rate. A core inflation rate that is too low from the ECB's perspective, coupled with economic growth that is too weak to change this fact, currently clearly argues against a rate hike. Economic growth should recover in coming quarters and should be stronger next year than this year. But even so this will at best lead to a minor increase in the pace of inflation. Thus, while the ECB should implement rate hikes next year, uncertainty remains high. But the probability has increased, as wage growth has accelerated since last year, which has at least created the conditions required for rising inflation rates and thus for an increase in interest rates as well. We expect that the deposit facility rate will be hiked in June, which should be followed by a hike of the main refinancing rate in December 2020.

US – markets misjudge interest rate risk

The Fed has adopted a wait-and-see stance for the moment. We expect that the economy will continue to perform well and that another rate hike will be implemented by the end of the year, which the markets do not expect at present.

The Fed is in a very comfortable position. Full employment has been attained and inflation is tame, currently perhaps a tad too tame. Economic growth is at the same time robust and seems set to remain above its potential. In this environment the central bank can afford to leave interest rates unchanged for the time being and take time to assess the diminishing impact of the tax cuts and the weakening of economic growth in China and the euro zone to play out. In addition to this, the Fed probably wants to give the stock market time to settle down.

What could trigger a response by the FOMC? What is decisive for our outlook is the fact that while a slowdown in economic growth is becoming evident, it starts from very strong levels. The Bloomberg analyst consensus currently expects GDP growth of 2.6%, we expect 2,5%. This is clearly above the growth potential of the US economy. Moreover, wage growth has already begun to accelerate and the labor market is likely to remain tight. The central bank will therefore probably have to adjust the level of interest rates further. We expect an rate hike not before the end of the year, as it will probably take that long for the cautious decision-makers at the FOMC to gain the necessary conviction.

The decline in core inflation rates since the beginning of the year poses a risk to our forecast of a further US rate hike. However, the decline is not a general trend, but is confined to just a few areas. Overall, we currently see no general trend in inflation rates in one or the other direction. We rather expect a sideways movement in core inflation, with recent levels representing the lower boundary of the range.

Market-based interest rate expectations are currently pointing toward a rate cut. This is not least due to the massive pivot in interest rate expectations by the Fed leadership in March. The median of interest rate projections of FOMC members declined abruptly from two rate hikes until the end of 2019 to no rate hike. That signaled a change in the environment to the financial markets that was not confirmed by economic data since. We believe that the decision-makers at the Fed will slowly readjust their assessment. The next indication for this could be the new survey of FOMC members that will be published in June.

 

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