The US interest rate cycle and what it means for SA bonds
The path of US rates is arguably the most important debate for SA bond investors, alongside SA’s ability to consolidate its fiscal position. Our analysis attempts to highlight the extent to which the US’s rate path is uncertain because prevailing conditions differ markedly from those during previous cycles, specifically with respect to monetary policy and trend growth. We hopefully also provide a broad framework and a set of parameters within which to frame and evaluate US real rates and their implications for SA bonds.
Over the long run, the neutral real policy rate, also referred to as r-star, provides an anchor for maintaining macroeconomic equilibrium, supporting full employment and keeping inflation constant. It is also a benchmark for measuring whether monetary policy is accommodative or restrictive. From a cyclical perspective, a central bank aims to run accommodative monetary policy when inflation is running below target, and vice versa.
Post the Federal Open Market Committee’s (FOMC’s) 50 basis point (bp) cut in September, the real federal funds rate is 2.4% (using spot core PCE inflation). This is 165bp above r-star, estimated by the New York Fed to be 0.75% (Figure 1). The last time the real rate was this restrictive was in mid-1990, when trend GDP growth was around 3.0% and accelerating, as opposed to trend GDP at 2.3% currently, with economic activity looking set to slow. This implies that the real fed funds rate is restrictive with respect to both the neutral real rate and trend GDP.
Figure 1: The US neutral rate versus the real fed funds rate
Source: Federal Reserve Bank of New York, Matrix
The path of r-star as the US cycle turns
Since 1990, the real fed funds rate has spent more time below the estimated real neutral rate than above it, averaging 60bp below prior to the Global Financial Crisis (GFC) and 160bp below post the GFC (Figure 1). Prior to the GFC, from 1990 to 2007, the real fed funds rate in the US averaged 2.4% (the nominal policy rate averaged 4.5%, and core PCE inflation averaged 2.2%), equating to 60bp below the New York Fed’s estimated r-star of 3.0%.
Post the GFC, between 2007 and 2020, inflation and rates across developed markets saw a secular shift lower. In the US, the real fed funds rate averaged -0.5% (the nominal policy rate averaged 1.0% and inflation 1.5%), a significant 160bp below r-star of 1.1%.
The onset of COVID saw a sharp contraction in growth and inflation in the second quarter of 2020. However, from the third quarter, as the economy lost capacity and potential GDP shifted lower, the output gap widened rapidly, from negative 0.9 to positive 6.9 in 1Q2021; real GDP growth accelerated well above its 2.3% trend (Figure 2). In response, inflation accelerated, from -0.8% in 2Q2020 to 5.8% in 1Q2021. Adding fuel to the inflationary fire, the neutral real interest rate reached a cyclical peak of 1.6% while the real fed funds rate fell to -5.7% (Figures 1 and 3).
From its peak, the output gap has closed and is now almost zero (Figure 2). Inflation has slowed to 2.5% year-on-year and indications are that the manufacturing sector has been in recession for some time. These factors alongside a significantly weaker labour market have prompted the US Federal Reserve (Fed) to enter a rate cutting cycle, as fears of an economy-wide recession mount.
Currently, derivative markets imply more than 200bp of additional cuts by the Fed, taking the nominal policy rate to 2.8% by the first quarter of 2026. This assumes that inflation will fall to its 2.0% target which, when added to r-star, estimated by the NY Fed to be 0.75%, takes the fed funds rate to 2.75%. However, it would be highly unusual for the real policy rate to settle at the neutral rate (Figures 1 and 3), and it will become increasingly necessary for investors to take a view on a cyclical trough in real US rates.
Looking at previous cycles and taking a simplistic approach, if the current real rate cycle were to imitate pre-GFC cycles, then real rates could trough between 0.0% and -1.2% (Figure 1).
Another approach is to use the real interest rate gap – the degree to which the real policy rate moves above or below the neutral rate through a rate cutting cycle (Figure 3). If we assume the neutral real rate remains at 0.75% then the real interest rate could trough between 0.15% (60bp below neutral) and -0.85% (160bp below neutral). These estimates assume no recessionary conditions in the US.
Figure 2: The neutral US real rate versus the US output gap
Source: Federal Reserve Bank of New York, Matrix
Figure 3: The difference between the real fed funds rate and the neutral real rate
Source: Federal Reserve Bank of New York, Matrix
Implications for SA government bond fair value
We use the above estimates of the where the US real rate could trough in our SAGB 10-yr fair value model, which incorporates US 5Y treasury inflation-protected securities (TIPS) as an independent variable.
The US real yield curve is currently still significantly inverted, at -144bp (Figure 4). It is likely that over the next 12 months the curve will flatten and possibly even steepen to 100bp. Using this as a rough guide, we estimate 5Y TIPS could trough between -0.85% and + 1.15%% respectively (Figure 5). As US 5Y TIPS trough, our model estimates the range for the fair value of SA’s generic 10-yr local currency bond at between 9.7% and 10.5%. The above assumes no recession in the US.
Figure 4: US real yield curve (5Y TIPS minus real fed funds rate) is inverted
Source: Bloomberg, Matrix
Figure 5: SAGB fair value based on US 5Y TIPS scenarios
Source: Federal Reserve Bank of New York, Bloomberg, Matrix
US r-star is at an historic low, will it stay there?
A complicating factor with respect to forecasting US rates is that 0.75% marks an historic low for the neutral real rate. Over the longer term, beyond the next 12 months, market participants must also weigh up the probabilities of whether r-star will return to its pre-GFC average of 3.0%, its post-GFC average of 1.1%, or somewhere in between.
The rule of thumb has been that the neutral real rate should approximate potential GDP growth. This was the case in the US up until the GFC (Figure 4). Importantly, there has been a structural change in the relationship between trend growth and r-star post the GFC; the neutral rate has fallen below potential GDP and until 2020, it averaged 75bp below trend GDP. Currently, the neutral real rate (2.4%) is at an historic low of 165bp below trend GDP.
In summary, while the real rate is restrictive versus the neutral rate, the neutral rate is at its most accommodative versus trend GDP. Research by the NY Fed suggests that this has to do with the fall in labour productivity requiring more accommodative monetary policy to produce the same growth in economic activity. For trend GDP to rise without inducing inflation, productivity needs to increase.
Figure 6: The neutral real rate has increasingly diverged from trend growth
Source: Federal Reserve Bank of New York, Matrix
Using our bond fair value model to estimate SAGB yields based on US real rate scenarios, implies that there is room for SA bond yields to fall from here, even if the US does not enter recession. Next month, post the Medium-Term Budget Policy Statement (MTBPS), we will look to add SA debt/GDP to our scenario analysis.