Focus
February 03, 2023 | 13:17
The Longer-Term Outlook for Long-Term Rates
The Longer-Term Outlook for Long-Term Rates |
With the Bank of Canada clearly signalling that rate hikes may be drawing to a close, and the Fed edging in that direction as well, market focus is turning to when rate cuts may commence. For the record, we believe rate reductions will be a story for 2024, primarily due to stubborn core inflation trends and a resilient job market. But the more interesting issue may instead be: Where do rates ultimately settle when we are beyond this inflation episode? That is still very much open for debate, and is probably much more important than precisely when central banks begin to reverse course. In a nutshell, we expect that the landing spot for rates will be notably higher than in the decade prior to the pandemic, with Canadian rates in the 2.5%-to-3.0% zone, and the U.S. a bit higher than that. We lay out the factors behind that conclusion below, as well as some key implications for fiscal policy, housing, and financial markets. The building blocks for long-term interest rates start with the overnight rate set by central banks. The past year has seen a dramatic surge in policy rates to combat inflation, leaving them well above where the so-called “neutral” rate was perceived to be for the past decade. The neutral rate is where policy is neither stimulative nor restrictive, or the sweet spot. The theoretical level combines expected inflation and real interest rates. The Bank of Canada believes neutral is in the 2%-to-3% range—its estimate fell consistently in the lead-up to the pandemic amid low inflation and sluggish growth—while the Federal Reserve’s assumed neutral range is a touch higher at 2.25%-to-3.25%. The tumultuous events of the past three years, and a potentially altered post-pandemic landscape, suggest that the neutral rate could take a trip higher. For now, our thinking is in line with the BoC at 2.5% for Canada, with the U.S. modestly higher at 2.50%-to-2.75% (Chart 1). |
The two decades heading into the pandemic were characterized by globalization and the integration of China and other emerging markets into the global economy. The resulting increase in the global labour force and productive capacity acted as a positive supply shock and a persistent headwind on goods inflation. For example, U.S. core goods inflation was exactly zero from 2000 to 2020 (Chart 2). That highly favourable backdrop for low inflation is gone, with the world unlikely to find another massive increase in labour supply, as well as rising geopolitical tensions, and the trend toward friendshoring. Layer on the cost of decarbonization, and it’s easy to see why inflation could trend at least modestly higher than pre-pandemic norms, especially for goods. |
The pandemic and policy reactions drove a rapid acceleration in inflation, with ongoing uncertainty around how quickly it will return to target. Part of the price surge was the result of the massive fiscal stimulus, which was accompanied by ballooning government debts. Higher debt burdens and the clear appetite of governments to spend aggressively in a crisis, combined with the inflation spike, suggest bond yields will have a somewhat higher term premium embedded than over the past decade. The path for real interest rates has many drivers, most of which are difficult to quantify. The outlook for economic growth is an input, as central banks want to ensure real rates are calibrated to ensure supply and demand are balanced to keep inflation in check. In Canada’s case, ramped-up immigration targets point to firmer economic growth and could necessitate a higher real rate. However, other factors, including global savings/investment dynamics, could continue to put downward pressure on interest rates, primarily further out the curve. And, the quantitative easing that central banks have engaged in for most of the past decade has put clear downward pressure on rates, with most now headed in reverse. Where does that leave interest rates over the medium term? Moderately higher trend inflation and a larger risk premium point to higher rates than over the past decade. However, those factors will be somewhat offset by the global savings glut and the lingering spectre of more QE. Looking at longer-term rates, Canada 10-year yields are expected to be around 2.75%, keeping the yield curve positively sloped, with the U.S. 10-year somewhat higher near 3% (Chart 3). Those assumptions are both nearly 100 bps higher than the average yield of the past ten years. |
What are the implications of this higher landing zone for interest rates, after the dust settles on the current inflation episode? We consider three broad areas: Fiscal Policy: While our assumed landing zone for long-term yields is generally a little below today’s levels, the impact of the 2022 blast-off in rates has yet to fully weigh in on government finances. That’s because the lion’s share of public debt is long-term in nature and rolls over only gradually. Even so, the rapid run-up in interest rates in the past year has already begun to affect government finances in a taste of what’s to come. In Canada, public debt costs have risen markedly, with Ottawa’s interest outlays climbing above $30 billion in the past 12 months from little more than $20 billion in 2020 and 2021 (Chart 4). Similarly, Washington’s net interest costs rose more than 40% last year, taking the 12-month tally to above US$517 billion by December. This rising interest burden leaves less manoeuvering room for policymakers (less space for discretionary spending), and is thus at least an indirect force behind the coming showdown over the U.S. debt ceiling. |
Still, interest charges remain sedate from a long-term perspective, at least for Ottawa. For example, Canada’s federal debt charges in the past year are still only slightly above 1% of GDP, up from the modern-day low of 0.9% in 2020, but far from the record highs of more than 6% of GDP in the early 1990s. The big difference with the bad old days of three decades ago is that real interest rates have shriveled. Our call would leave nominal rates barely above the medium-term outlook for inflation, whereas 10-year bond yields were on average a full 5 percentage points above inflation in the 1990s, creating an incredibly challenging debt dynamic (Chart 5). We don’t foresee a return to that set of circumstances. Still, the net interest burden for Washington has risen to 2% of GDP, up from little more than 1% in 2015, and not far from the highs of just above 3% in the early 1990s. Housing: The steep back-up in interest rates has hit the reset button on a wide variety of asset price valuations, including housing. No doubt, some of the big home price move in the past year in North America was exaggerated by the boom/bust in activity amid the unique backdrop of the pandemic. Our view is that the housing market in both economies is still digesting the steep rate rise, and the price correction has yet to fully run its course. Looking further ahead, the expected retreat in short-term rates—presumably by 2024—should put a floor under the market, with Canada supported also by robust population growth. Still, with yields expected to settle in at a higher level than pre-pandemic trends (let alone the extreme lows during the depths of 2020), we don’t expect much headroom for home prices over the medium term. |
Chart 6 looks at a typical monthly mortgage payment as a share of disposable income in Canada over many years—a rising line denotes a deterioration in affordability. The pandemic housing boom unsurprisingly crushed affordability, and matters have barely improved since as the retreat in home prices in the past year has been offset by higher interest rates. In this projection, even flat home prices over a five-year period will only bring affordability to somewhat less unaffordable levels. U.S. housing affordability was also walloped in the past few years, dropping even below the lows in 2006, albeit in line with the early 1990s. As in Canada, there will be limited potential for significant U.S. home price appreciation in our interest rate scenario, given the weak starting point for affordability. Financial markets: In some respects, it’s a similar story to housing for many financial markets, as almost all asset prices are readjusting to the new rate reality. Of course, in contrast to housing, financial market pricing can adjust almost instantaneously to new information, and our long-term view on yields is not markedly different from what’s already largely built into the yield curve, with perhaps a modest upside bias. Still, most markets have precious little risk premium built in at the moment, and are potentially vulnerable to any negative surprises, whether it’s on the inflation/rate front or on the growth outlook (perhaps due to a geopolitical shock). |
One way to consider that reality is to look at the S&P 500’s forward earnings yield (the inverse of the P/E ratio) versus the 10-year Treasury yield (Chart 7). A large positive gap would suggest that the equity market is cheap relative to bonds (such as in the post-Financial Crisis era around 2010/11), while a deeply negative gap points to equity overvaluation (with the 1999 tech bubble the prime example). Note that the twin bear markets of 2022 in both stocks and bonds actually left equity market valuations the worse for wear, with the back-up in bond yields dominating. Looking ahead, it’s a fair debate—and a topic of a future piece—whether these relative valuations ultimately return to the “norms” of the early-to-mid 1990s (i.e., a more positive outcome for equity markets) or the pre-pandemic “norms” (i.e., pointing to further softness for equities). But the key conclusion is that even with last year’s market damage, the new rate backdrop does not leave relative equity valuations as particularly cheap. |