Will interest rates “neutralise” in our lifetimes?

The Federal Reserve’s (Fed) decision to delay raising interest rates in the wake of fears over the health of China’s economy highlights the conundrum facing central bankers, so when will interest rates rise and will I be dead before rates match GDP growth rates (“neutralise”) again?

28 October 2015

Michael Lake

Michael Lake

Investment Director, Fixed Income

What is the market pricing in?

Current market pricing suggests rates in the US and UK will take more than 20 years to return to a ‘neutral’ level – the rate at which nominal rates equal the GDP growth of a country.

In the case of Europe and Japan, according to current market pricing, rates will apparently never approach this neutral level. Meanwhile in the US and the UK some of us will be retired or even dead before we reach this level.

The real rate of interest removes inflation to reflect the real cost to a borrower (or real yield to an investor) and is represented by the nominal interest rate less inflation.

In the UK and US, real rates are currently at or close to 0%, while in Europe and Japan they’re negative.

Looking ahead 12 months, based on market pricing of future inflation and interest rates, all real rates are negative.

This indicates an increase in inflation that is not expected to be countered by an increase in interest rates.

In other words, rates remain on hold across the globe.

When will rates hit neutral?

The market assumes that things will improve slightly in the US and UK in three years time, but will remain broadly the same or get slightly worse in Europe and Japan.

On a longer- term horizon though, most investors agree both interest and inflation rates will go up, but the big question is: when do we get back to a neutral rate?

As discussed, interest rates are said to be neutral when the nominal rate is equal to the annual rise in gross domestic product (GDP).

For the UK, assuming GDP growth of 3% and using the Bank of England inflation target (2%) as the average inflation component, the assumed neutral real rate would therefore be 1.0%.

Clearly, current market projections suggest this will be a long way off.

Neutral before I die?

As a thirty-something then yes, before I die, but on these estimates I would still have enough time to have children, watch them go to school, and even see them have a gap year and graduate before rates reached a neutral position.

Given low unemployment, a more confident business and consumer outlook in both the US and the UK and positive economic growth, the market outlook is far too bearish and is not pricing-in an appropriate level of interest rate increases.

But if the glacial rate of change expected is inconsistent with the economic backdrop, it may also end up being at odds with the pace at which central bankers end up having to raise rates.

Bond investors should therefore be prepared for volatility ahead.

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