Futures markets are forecasting long-term interest rates barely higher than the Federal Reserve’s 2 percent inflation target. Will interest rates stay near zero forever, or are the market’s expectations the result of a temporary distortion?
Futures markets anticipate fewer interest rate hikes in the coming years than the Federal Reserve’s Open Market Committee (FOMC). The FOMC, the body that sets short-term interest rates, forecasts gradually hiking rates toward a 3 percent long-term target; the committee’s members generally expect rates to find a long-term equilibrium about one percentage point above inflation. Futures markets, however, predict a remarkably flatter trajectory, with rates not expected to ever surpass 2 percent.
It would appear that the market doubts the Fed’s ability to meet its official 2 percent inflation target. But there may be a simpler explanation for weak interest rate expectations: Quantitative easing programs in Europe and Japan have successfully driven down long-term rates, even in the US.
Are futures markets' soft interest rate expectations a sign of risks facing the broader economy? If investors are growing nervous, we would expect their anxiety to quickly be reflected in the equities market. But stock valuations appear consistent with a strengthening economy approaching the top of the business cycle. Equities are near an all-time high, and the market’s rise has been based on strong corporate earnings and the potential for further growth.
As the US economy moves closer to operating at its full capacity, interest rates will need to rise. Higher rates will be necessary not only to control inflationary pressure, but also to prolong the business cycle’s peak and prevent the development of economic imbalances. As full employment approaches and wages finally begin to lift off, real interest rates will eventually climb into positive territory and find an equilibrium that rests above inflation.
If interest rate futures are not predicting a downturn, then why does the market seem to doubt the eventual normalization of interest rates? Perhaps the market’s low long-term expectations result from the distortions of quantitative easing (QE) programs abroad. QE is an unconventional form of monetary stimulus in which central banks purchase government bonds in an attempt to push down the cost of long-term borrowing. By depressing the yield on long-term government debt, QE encourages private capital investment and spurs economic activity.
The Federal Reserve’s QE program has been tapered for several years, but large scale asset purchasing in Europe and Japan continues to remove some $2 trillion from bond markets annually. Although these programs do not directly purchase US Treasurys, international investors are finding themselves squeezed out of the eurozone and Japanese bond markets, and capital is flowing into US debt.
The impact of QE on the bond market is visible in falling yields and negative term premiums. QE constricts the global supply of safe government bonds, pushing real yields to near zero. The “term premium” that investors typically demand for parking their money in long-term investments has actually turned negative—investors are willing to accept yields on 10-year Treasurys that are lower than the returns they would expect to earn on short-term money market loans. This is a repeat of the bond market’s behavior during the Federal Reserve’s quantitative easing program from 2010 to 2013.
It's likely that suppressed bond yields are skewing the futures market’s interest rate expectations. Since public debt and private loans compete for capital, the yield offered on long-term government debt is often used as a proxy for the natural “risk-free” interest rate. When long-term bond yields are distorted, expectations for interest rates follow suit. As global growth resumes, Japan and Europe will likely taper their QE programs, and if history is any guide, yields and interest rate expectations will eventually return to their true equilibrium levels.
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