Never mind getting all bent out of shape over short-term rates ..... what's your view on "r * " ?

Friday 9th September 2016

Never mind getting all bent out of shape over short-term rates ..... what's your view on "r * " ?

ref:- "Investors tune in to Fed's long-term forecast", Analysis. Policy Outlook, The Financial Times, Markets and Investing

First, a definition:

" r *:  the "neutral" or "natural" interest rate that is consistent with stable, non-inflationary economic growth  --  in other words, the final station in the central bank's interest rate normalisation journey where r stands for interest rate and the star denotes its long-term nature." The FT

Given the fact that just about every market we ever look at (you name it: bonds, equities, currencies, commodities) is subject to Fed policy, it's not surprising that economists and investors tie themselves in knots trying to second-guess the Fed's decisions on short-term rates. But there's a view that we really should be paying more attention to the forecasts for longer-term rates. Rick Reider of Blackrock points out that it's at the longer end of the yield curve that mortgages and investment get funded, and therefore the forecasts for that area actually matter more than exactly when the Fed decides to lift short-term rates.

As the ever-repeating speculation of whether the Fed is going to hike the rate now or later illustrates, predicting the precise path of short-term rates is far from easy. Imagine then how difficult it is to forecast long-term rates. So we should all look very closely therefore at the Fed's view of where rates should peak and the implications for all financial markets. Unfortunately, the Fed's crystal ball has proved to be as cloudy as the next man's but their repeated downward revisions to long-term rate predictions reflect an increasingly downbeat view for the future.

In 2012, the Fed estimated that the "natural" long-term US interest rate (r *) at 4.25%. By last December this had been marked down to 3.5%, and in June it was trimmed again to 3.0%. Don't be surprised if there is another downward revision later this month. Critics argue that these adjustments are just another case of the Fed catching up with market thinking. The 10yr Treasury forward (a bond derivative that reflects the market's view of where 10yr treasury yields will be in 10 years time) traded down to 2.6% recently, against a long-term average of 5.5%. 30yr Treasury bonds are still yielding little more than their recent record low of 2.1%, against a long-term average of 6.83%. All in all, the Fed's gloomier predictions are undeniably moving closer in step with those of the market.

The implications of scaling down projections for long-term rates are felt even in the present decision-making debate. Any policymaker is bound to move more cautiously in raising rates now if they see a darker picture for the future. Or as ex-Fed Chairman Ben Bernanke put it:

"A lower value of r * implies that current policy is not as expansionary as thought. With a shorter distance to travel to get to a neutral level of the Fed Funds rate, rate hikes are seen as less urgent EVEN by those participants inclined to be hawkish."

Well, quite ..... though we should point out that not all members of the Fed would embrace these bearish projections.

You may have come across the "natural" rate of interest, or " r * ", when John Williams of the San Francisco Fed made reference to it in a recent speech that attracted much attention. His point was that the Fed should raise its inflation target when r * is low. It's a loose and expansionary approach, too loose for current Fed thinking for sure, but that such a senior figure should suggest it implies that that the argument for greater tolerance of inflation may be gaining a foothold.

A falling natural rate of interest is of more than just academic interest. Take equities for example ..... in part, stocks are valued on long-term, safe bond yields that are used to discount their future cash flows. Theoretically if the risk-free rate of interest declines then , all else being equal, equities become more valuable, according to Joshua Feinmann of Deutsche Asset Management. The flipside to that of course is that if falling r * reflects a stalling economy rather than other factors such as ageing demographics and higher levels of saving, the effect on share prices will be decidedly less welcome.

As ever, not everybody is convinced that we should get overly concerned with r *. That's all very well, but if the Fed keeps making long-term forecasts it's guaranteed that investors will keep analysing them ..... if only for pointers to more immediate policy decisions.