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Investors are betting US interest rates will remain significantly higher than the Federal Reserve’s own estimates by the end of a looming rate-cutting cycle, as markets increasingly focus on where borrowing costs will settle.
The market-implied probability of the Fed’s benchmark interest rate is about 3.6 per cent from 2027, making traders’ predictions for the so-called terminal rate far higher than the central bank’s median estimate of 2.6 per cent in its “longer run” projection.
Investors’ bets on higher long-term interest rates come as the outsize strength of the US economy has forced them to scale back their expectations for extensive interest rate cuts this year. Rapid developments in artificial intelligence and high government spending plans have boosted forecasts that rates will not fall as much as previously predicted.
“The market is thinking that terminal rates are likely to be higher relative to the Fed and recent history,” said Guillermo Felices, global investment strategist at PGIM Fixed Income.
“The key thing that the market is trying to reprice is the outlook for long-term economic growth in the context of the new productivity story we are hearing about — driven by artificial intelligence and the potential for more fiscal spending.”
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Estimates for the so-called neutral rate of interest — the level at which the economy operates with full employment while keeping inflation close to central banks’ 2 per cent targets — have come into focus as most big central banks have started discussing interest rate cuts.
US inflation was higher than analyst forecasts in January and February and US manufacturing unexpectedly expanded in March for the first time since 2022. Last month the Fed nudged up its estimate for its long-term policy rate from 2.5 per cent to 2.6 per cent.
Loretta Mester, Cleveland Fed president and a voting member of the Federal Open Market Committee, said on Tuesday that she had upgraded her own estimate from 2.5 per cent to 3 per cent, on the back of the US economy’s resilience.
Even so, the central bank stuck to its forecast of three 0.25 percentage point rate cuts this year. Fed chair Jay Powell said he did not think recent inflation readings had “really changed the overall story” of price pressures easing to 2 per cent.
However, a closely watched gauge of long-term US inflation expectations, the five-year, five-year forward break-even rate, has remained in a tight trading range at about 2.2 per cent for the past two months. The rate is the markets’ assessment of annual price growth over the second half of the next decade.
Jan Hatzius, chief economist at Goldman Sachs, forecast that the US terminal rate would be between 3.25 per cent and 3.5 per cent, and that the Fed had “a little bit of status quo bias”. While the Fed has been moving up long-term rate forecasts, it has been moving up “more gradually than I would have predicted”, Hatzius said.
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Andrew Balls, Pimco’s chief investment officer for global fixed income, said the market pricing of 3.6 per cent was higher than his expectations of terminal rates.
He pointed out that market expectations can shift. In December pricing for where US rates would be in five years’ time dipped below 3.2 per cent when encouraging inflation data triggered a flurry of bets that the Fed would begin cutting rates sooner than anticipated.
“For the most part we think a lot of the drivers for low equilibrium interest rates remain in place,” he said.
Similar to the US, markets are pricing that the Bank of England’s interest rate will settle at between 3.25 per cent and 3.5 per cent, significantly higher than less than 1 per cent in the decade before the coronavirus pandemic.
Pricing for the European Central Bank, which has a benchmark rate of 4 per cent and was negative between 2014 and 2019, is between 2 per cent and 2.25 per cent from 2027 to 2029 — in line with the market’s expectations for long-term inflation, implying expectations of little to no growth.
Unlike the Fed, the BoE and ECB do not publish predictions for long-term interest rates. Market-implied, long-term inflation expectations across the three central banks have remained broadly anchored over the past two years at between 2 per cent and 2.6 per cent.
Holger Schmieding, economist at Berenberg, said European inflation was “structurally higher than in the past” and the impact of demographic change — higher wage demands and fewer workers — and the ongoing cost of climate protection, defence spending and the restructuring of supply chains are all adding to inflation.
“A higher underlying inflation rate means the nominal central bank rate needs to be higher,” he said.
PGIM’s Felices expects rates to settle lower in Europe than the US owing to its “anaemic” growth. “The big question is whether pricing for the UK is right . . . The productivity story has been dismal . . . can the UK generate growth in a sustainable way of around 1 per cent?”
