US: How long-term interest rates react to the monetary policy normalisation? - Natixis

It is increasingly clear that the Federal Reserve is going to continue to normalise its monetary policy: three hikes in the Fed Funds rate in total in 2017 and again in 2018; reduction in the size of the Federal Reserve’s balance sheet at a growing pace, points out Patrick Artus, Research Analyst at Natixis and tries to list down the effects, that this normalisation will have on long-term interest rates in the United States?

Key Quotes

“Two scenarios for the dollar yield curve

- If dollar long-term interest rates are low because of an expectation error regarding the Federal Reserve’s monetary policy (the normalisation is underestimated), then the dollar yield curve will gradually rise across all maturities;

- If dollar long-term interest rates are low because of the abundance of liquidity, the dollar’s role as a reserve currency and the role of Treasuries as a risk-free asset, then the US yield curve will flatten (short-term interest rates will increase less than long-term interest rates).”

“The reality may sit between these two scenarios, as both explanations of the low level of dollar long-term interest rates are probably simultaneously valid. “It is not easy to choose between these two hypotheses, both of which are probably correct.”