Higher for longer, no more

The drivers that pushed US interest rates up in 2023

In May, the Congressional Budget Office forecasted an average budget deficit of -6.1% over the next 10 years. In Europe, deficit rules are likely to be re-introduced: any country exceeding -3% will enter an Emergency Deficit Procedure with the EU Commission.

In July, the Q3 refunding announcement was $274bn higher than estimated in May.

In August, Fitch downgraded the US from AAA to AA+, citing expected fiscal deterioration, high and rising government debt and erosion of governance.

In September, the US Congress averted a government shutdown at the last minute with a deal to fund agencies for 45 days. This was followed by the first-ever removal of the Speaker of the House.

Recently, Moody’s put its outlook to negative and estimated the ratio between interest expenses and government revenue to increase from <10% in 2022 to 26% in 2033.

The Federal Reserve hiked its policy rates more than expected as the economy remained resilient notwithstanding the higher interest rates. Growth accelerated to a relatively strong 5.1% QoQ in Q3. Also, the Bureau of Economic Analysis revised up the estimate of pandemic excess savings, that means consumers still have available cash to spend.

It is believed that the neutral interest rate, r*, will rise due to investments outstripping savings and an increase in productivity.

The structure of the US Treasury market has changed. In recent years, the main buyers have been the Federal Reserve through its quantitative easing programme, foreign central banks to build up foreign exchange reserves and domestic banks due to a surge in retail deposits. The price sensitivity of these buyers has been low. The term premium, i.e. the difference between the current long-term yield minus the expected compounding of short-term policy rates, became negative.

Over the past two years, these large holders have become net sellers. The Fed holdings dropped from $5.7 in mid-2022 to 4.7 trillion now. China held over $1 trillion at the start of 2022, compared to $780 billion in September 2023.

And the new buyers are much more price sensitive. All this at a time when the ratio of public debt to GDP is rising. This means that supply and demand balance out at higher yields. At the November auction of a new 30-year bond, the Treasury was required to accept a larger-than-normal discount over secondary market levels to allot the full $24bn size. The term premium has become positive again.

In the next year, the net supply plus Fed redemptions is high at $1.6 trillion. In the Eurozone, it is estimated at €600 billion.

The reversal in November & December 

The miss in the October CPI sparked a rally. It accelerated as the November Euro area CPI missed too. Then, Germany prospects dimmed as the constitutional court annulled the government’s decision to reuse unspent Covid funds.

Some weak signs are also emerging in the US eg delinquency rates for credit cards and auto loans are picking up.

Now, the market expects monetary policy to become significantly less restrictive next year, with policy rate cuts starting in the first half.

2024: expect another volatile year

Money supply and velocity are falling. Inflation may temporarily drop below target. However, financial conditions have loosened. Central banks may err on the conservative side and delay cuts if the economy remains resilient for few more quarters. Job openings have been falling sharply, and wage growth is easing, but the number of unemployed workers remains low and stable.

Short term interest rates will move lower. Long term ones may seesaw again due to the high uncertainty and data dependency.

More opportunities for active bond managing.