During the late summer, the central banks again took centre stage. Firstly, the US Federal Reserve announced a new flexible inflation target that will allow inflation to increase temporarily above the 2% target. The move comes after a period of sub-target inflation. Expectedly, we will learn more about the actual new structure after today's FOMC meeting.

With inflation persistently below 2% during large parts of 2019 and 2020, there are no indications that the Fed is in any way trying to move short-term rates higher, even if the US economy were to rebound.

The market is pricing for the Fed Funds Rate to remain at the current level until end 2024. The money market curve indicates a fair probability of the US also introducing negative interest rates – we see the chance of that as very slim, however. Fed chair Jerome Powell has several times rejected the notion of negative interest rates in the US, even during the very severe crisis in Q2 20. Moreover, negative interest rates were not an issue during the Fed's review of its monetary policy strategy.

Yet, the Fed can only control the short end of the curve. Rates further out the curve are driven by supply and demand, neutral real yields (r*) and inflation forecasts. The latter rose during the summer, especially in the US, as positive sentiment returned to the financial markets along with growing confidence in global central banks' ability to drive up inflation.

However, as the charts below show, US inflation forecasts (break evens) have risen, but nominal yields have not. As a result, neutral yields have dropped to around minus 1%. While there is no doubt that the US economy needs negative interest rates right now, we do not expect this to apply for the next 10 years. We expect the 10Y swap rate to climb to 1.1% over the next 12 months from the current level of just below 0.7%. Part of the increase is likely to reflect a slight move upwards in 10Y expected real yields in addition to inflation forecasts moving higher. The rest we would attribute to a reduction in safe haven purchases by investors, for example when a COVID-19 vaccine becomes available – expectedly in 2021.

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