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STRATEGY
Higher interest rates could be great news
Interview with Philippe Weber, co-head of Strategy at CPR AM
Philippe Weber
Since last summer, interest rates have begun to rise, albeit moderately, especially in the US. Why?
They have indeed. Since 1 July of last year, yields on 10-year government bonds have risen by almost one
percentage point in the United States and by almost half a percentage point in Germany. In the US yields
have risen on all maturities. The trend has not been steady – after inching up during the summer, yields
accelerated significantly with the election of Donald Trump. Things have stabilised somewhat over the
past few months except for the shortest maturities – we’ll get back to those later. There are many
reasons that yields have risen, but all can be summed up in one word: normalisation. Normalisation of
growth, normalisation of inflation, and normalisation of monetary policy – all three being intertwined.
10-year government bond yields
US
Euro zone
Germany
All comments and analyses reflect CPR AM’s view of market conditions and its evolution, according to information known at the time. As a result
of the simplified nature of the information contained in this document, that information is necessarily partial and incomplete and shall not be
considered as having any contractual value.
US yields
30Y
10Y
5Y
2Y
3M
Almost eight years after the end of the recession, why are we only now talking about normalisation?
Of course, the US has been expanding constantly since summer 2009. But the shock was such that both
labour and equipment were heavily underemployed. Nowadays, the economy is no longer heavily into
capacity under-utilisation. For example, the unemployment rate has returned to pre-recession levels,
including in its broader measure (which includes, for example, forced part-time work). Yes, the workforce
participation rate (i.e., the number of persons having, or seeking, a job compared to the population of
persons older than 16) has not returned to its previous level, but a significant portion of the difference is
due to natural attrition from the ageing of the population. As for equipment, the capacity utilisation rate
has levelled off, albeit at a level lower than before the recession. But, all in all, the output gap, i.e., the
difference between actual and potential production, has almost completely closed up very recently after
exceeding 4% in 2009.
United States
Output gap
Last 12-months inflation (right-hand scale)
All comments and analyses reflect CPR AM’s view of market conditions and its evolution, according to information known at the time. As a result
of the simplified nature of the information contained in this document, that information is necessarily partial and incomplete and shall not be
considered as having any contractual value.
The output gap cannot be observed. It can only be estimated through a set of assumptions and complex
statistical methods but the various estimates do converge, and this is an important indicator. It is usually a
good leading indicator of inflation and, moreover, is used in forming most monetary policy rules, like the
Taylor rule.
So, since you brought it up, is inflation moving back to normal?
Yes, it is. We had the feeling it was for several months, and today this is definitely the case. All indicators
are up, including the total consumer price index, the index ex-food and ex-energy, the PCE deflator (which
is the Federal Reserve’s official objective) – all are accelerating. Some regional Feds use alternative
measures of core inflation, for example, median inflation and, there again, the acceleration is clear. And
this is not due just to a basis of comparison, i.e., the purely arithmetic outcome of the fall in energy prices
one year ago. The acceleration has been even stronger over the past three months and neither energy
prices nor what happened one year ago have much to do with it. The Fed has therefore achieved its dual
mandate (full employment and 2% inflation, to sum up), and it has begun to raise rates. Here again, this is
a mere normalisation and even the start of normalisation. The key rate is still very low, and the pace of
tightening is extremely cautious and is being flagged as clearly as possible. We are likely to have at least
two more rate hikes this year and, in my view, even three.
So long bond yields were reacting to this key rate hike?
Yes, but not just to that. Long bond yields were reacting to flat growth, to the return of inflation to 2% (all
other things being equal, rates rise with inflation) and also to expectations – expectations of heavy fiscal
deficits, of greater growth, and perhaps even of more inflation when protectionist measures when Trump
was elected. And also expectations of coming rate hikes. But the Fed had flagged the March rate hike, for
example, so abundantly that the actual decision had no significant impact on long bond yields. Lastly, the
fact that the Fed is no longer buying up government paper and has even begun to shrink its balance sheet,
is no longer a factor in long bond yields, as it was in recent years.
Should we be happy or worried about these higher yields?
As thing now stand, happy. Happy, first of all, for what they stand for – the return to normal. And it was
about time, 10 years after the recession began! But happy, also for the rates themselves. For one thing,
low rates were, paradoxically, not a good thing for the banking system. Moreover, while lending rates are
higher, the remuneration of savings is also higher, and this penalises households less. Lastly, and most of
all, higher rates and a more pronounced hierarchy between maturities and between borrowers will limit
the risk of credit bubbles or asset price distortions. Obviously, at the same time, a rate increase, all other
factors being equal, could slow credit distribution and, hence ultimately, economic activity. We’re far
from that point, and, incidentally, a return to excess debt is not something to be desired at a time when
we are just emerging from the worst debt crisis in 80 years. As for the equity markets, empirical research
by CPR AM, which is corroborated by various broker publications, suggest that, below 3.5% and even 4%,
they don’t react to shifts in interest rates.
Will interest rates continue moving up?
Probably so. Economic growth is likely to at least stabilise at its current pace or even accelerate if all or
some Mr. Trump’s fiscal policies are implemented. True, we aren’t forecasting an explosion in inflation,
but it is likely to level off a little higher than 2%. With this in mind, the Fed is likely to continue raising its
Fed Funds target rate gradually, and this will drive long bond yields higher.
All comments and analyses reflect CPR AM’s view of market conditions and its evolution, according to information known at the time. As a result
of the simplified nature of the information contained in this document, that information is necessarily partial and incomplete and shall not be
considered as having any contractual value.
Will we move back to pre-recession interest rates?
Probably not, at least in the short term. The Federal Reserve has analysed this issue in-depth, particularly
to justify its cautious stance on raising key rates. According to the Fed, but also according to many
analysts, academics, and economists, in the private or public sector, what we call the neutral, or natural
rate of interest has fallen considerably. One definition of the neutral rate is the rate that, in the midst of
full employment, keeps inflation stable. And many factors have brought it down. In normal times, it is the
same as nominal growth – to simply things to an extreme, this correlation may be due to a constant
trade-off between investments in bonds and investments in the real economy. Unfortunately, nominal
growth has slowed. Real growth is weaker as the working population is expanding more slowly, and
labour productivity is now rising very slowly, and this is not being offset by moderate inflation. This alone
justifies a reduction in the equilibrium rate, but there are many other factors that are lowering it further.
Here are some of them.
Interest rates are the result of a faceoff between desired savings and desired investment. And we are now
seeing an increase in savings worldwide, including precautionary savings due to economic uncertainty,
savings due to the ageing of the population, and savings resulting from increased inequality, as the rich
save more than the poor. Moreover, many investors have switched to assets deemed less risky, including
US, German or Japanese government bonds, which is driving their yields down even further. And, lastly, in
an environment where there are no fears of an outright inflationary surge beyond the ongoing
normalisation, a saver will accept a lower remuneration than he used to, as his investment will be less
risky.
We have just seen that desired savings had increased but, at the same time, investment is lower than it
used to be. The slowdown in potential growth mentioned above has limited the prospects for companies
and, hence, their investment needs (hence, a vicious cycle – less investment and, hence, less productivity
and less growth). Prices of capital goods have declined – a computer costs less today than it did 10 years
ago and less than a machine tool. Fiscal austerity in many countries has caused public investment to
decline and there are areas in which the private sector will never invest. Lastly, companies are paying out
proportionally higher dividends than they used to, which, all other things being equal, limits investment.
So we can see that interest rates – both short-term and long-term – will not move back up to their precrisis level.
Potential growth and long bond yields
Potential nominal growth
10-year yields
All comments and analyses reflect CPR AM’s view of market conditions and its evolution, according to information known at the time. As a result
of the simplified nature of the information contained in this document, that information is necessarily partial and incomplete and shall not be
considered as having any contractual value.
Nominal growth and Fed Funds target rate
Nominal growth (18-month lag)
Fed Funds target rate
That doesn’t sound very encouraging…
Unless… unless, if the economy does it part and precautionary savings decline. If surplus-carrying
countries, China and Germany in particular, put through stimulus plans. If investment rises, in which case
productivity will, as well. And productivity can also come from better education and better training, and
technical progress. If interest rates were to rise for those reasons, then that would be great news!
Written on 31 March 2017
Information:
All comments and analyses reflect CPR AM’s view of market conditions and its evolution, according to information known at the
time. As a result of the simplified nature of the information contained in this document, that information is necessarily partial
and incomplete and shall not be considered as having any contractual value.
This document has not been drafted in compliance with the regulatory requirements aiming at promoting the independence of
financial analysis or investment research. CPRAM is therefore not bound by the prohibition to conclude transactions of the
financial instruments mentioned in this document. Any projections, valuations and statistical analyses herein are provided to
assist the recipient in the evaluation of the matters described herein. Such projections, valuations and analyses may be based on
subjective assessments and assumptions and may use one among alternative methodologies that produce different results.
Accordingly, such projections, valuations and statistical analyses should not be viewed as facts and should not be relied upon as
an accurate prediction of future events.
About CPR Asset Management:
CPR AM is an investment management company certified by the French Financial Markets Authority, an autonomous and wholly
owned subsidiary of Amundi Group. CPR AM works exclusively in third-party investment management (for institutional,
corporate, insurance, private banking, fund management, and wealth management clients). CPR AM covers the main asset
classes, including equities, convertibles, diversified investments, interest rates and credit).
CPR AM in figures (End-December 2016) - €39.2 billion in AuM - More than 100 employees, more than one third of whom are
involved in investment management.
CPR ASSET MANAGEMENT, limited company with a capital of € 53 445 705 - Portfolio management company authorised by the
AMF n° GP 01-056 - 90 boulevard Pasteur, 75015 Paris - France – 399 392 141 RCS Paris.
cpr-am.com
@CPR _AM
cpr-asset-management
All comments and analyses reflect CPR AM’s view of market conditions and its evolution, according to information known at the time. As a result
of the simplified nature of the information contained in this document, that information is necessarily partial and incomplete and shall not be
considered as having any contractual value.