While the Federal Reserve controls short-term interest rates – by altering the Federal Funds Rate – longer-term interest rates are largely driven by a combination of future economic growth, inflation expectations and relative interest rates. During a time in which real US GDP growth has averaged 2.5 per cent year on year over the past two years, as of July 11 the 10-year Treasury yield is down 77bps over the past year, begging the question: why? As seen in Exhibit 1, the 10-year yield has followed both inflation expectations and PMIs lower.
So, what’s next for interest rates? According to data from the CME, as of July 10th, there is a 100 per cent chance of at least one rate cut at the July 31 FOMC meeting and an 89 per cent chance of at least one more cut before the end of the year. All else remaining equal, easing moves from the Fed would likely give a short- to medium-term boost to economic activity. The US consumer is in good shape – strong labor market, improving wages and high confidence – which will likely keep demand strong. These positive factors suggest higher rates in the short term. According to data from Bloomberg, economists’ median forecast for the 10-year Treasury yield by yearend is 2.31 per cent (roughly 25bps higher than current levels). We believe that by December 31 rates could surprise to the upside and end up in the 2.50-2.75 per cent range.
However, low inflation and the value of government bonds with negative yields swelling to $13 trillion (making US Treasuries look relatively attractive) could continue to keep a lid on rates until global economic activity picks up. Moving forward we will be closely monitoring any signs of global growth rejuvenation along with US inflation data.