The Glass Ceiling on Rates

200+year interest ratesMy Comments: I’ve recently shared this chart with you that shows the historical ups and downs on interest rates in this country going back 224 years. They have been trending down since 1981, a long time. Right now they are nearly zero.

When this happened in the past, they began an upward climb until they reached the point where the rate stifled economic growth and a downward trend began. The economy is now growing and with the debt-to-GDP ratio at historic highs, the Fed doesn’t have much room to maneuver on the federal funds rate. But they will inevitably start to rise, probably this year, raising the next questions: how high and how fast.

February 19, 2015 by Scott Minerd @ Guggenheim Partners

The release recently of the minutes from the Federal Reserve’s Jan. 28 meeting sparked a frantic hunt for fresh clues about the timing and pacing of a federal funds rate hike. The question no one seems to be asking is once the Fed commences down the road of raising rates, how far will they ultimately go? Based on research we’ve conducted on the impact of higher rates on the U.S. debt burden, it appears the terminal value for the fed funds rate—the point at which the Fed stops tightening in a cycle—is around 2.5 to 3 percent, a lot lower than many people expect.

In the near-term, the stage is clearly set for the Fed to begin what it has been referring to as “policy normalization.” While consensus may be growing that the first of the coming rate increases will commence in June, I think the Fed will likely be more cautious and begin its “liftoff” in September. After that, the Fed is likely to raise rates by 25 basis points every other meeting. Practically, this means the overnight rate should be in the 50- to 75-basis-point range by the start of 2016.

Longer term, the Fed will likely continue to tighten at a steady pace until it nears the terminal rate in the cycle, which I believe will occur toward the end of 2017 or early 2018 in the range of 2.5 to 3 percent. Supporting such a ceiling on the fed funds rate is research that shows a close historical relationship between the debt-to-GDP ratio in the economy and the terminal fed funds rate.

At 233 percent, the amount of debt as a share of GDP, excluding the financial sector, is among the highest since data became available in 1947. Given this level of debt in the economy today, and assuming the same pace of leverage expansion for the upcoming rate hike cycle as that during the 2004-2006 cycle, a terminal rate around 2.5 percent is where the economy is likely to begin to slow to an extent that forces an end to the tightening cycle. Knowing that policymakers typically overshoot, 3 percent would be in the cards as a possible terminal fed funds rate, which is within the standard error of estimate for the model. A recession typically occurs about a year after we reach the terminal rate, so if this tightening cycle plays out as I suspect, the U.S. economy won’t face its next recession until 2018 or 2019.

Why is the end of a Fed tightening cycle a concern today? Well, the yield curve generally flattens substantially by the end of a tightening cycle. In other words, 10-year Treasuries typically trade very close to the overnight rate (maybe 25 basis points higher). Therefore, understanding the economic constraints and terminal rate value of the upcoming “normalization” process can provide long-term investors with insights into the potential ceiling on 10-year Treasury yields, as well. In this case, if our view of the terminal fed funds rate is correct at 2.5 to 3 percent, then the end of the cycle in 2017 or early 2018 could see a ceiling for the 10-year note around 2.75 to 3.25 percent—a level much lower than many investors may be anticipating.