Rates Spark: Why central banks struggle to control interest rates

As the Fed is about to embark on the first of what we expect will be an eight times 25bp hiking cycle, it is useful to remind ourselves of the role central banks have in influencing long-dated interest rates. In all likelihood, a more hawkish Fed, for instance moving its dot plot to close to the number of hikes we’re expecting in this cycle, would push rates higher. The fact that the curve is already pricing a path very close to our own expected trajectory for the Fed Fund rates suggest that this would be far from a surprise, however.

Balance sheet reduction is likely to be phased in over the second half of this year, an eternity in financial markets

In theory, its tone would also help inform markets about the fate of its balance sheet reduction plans, something that should, in principle, influence long-dated interest rates more directly. In practice, it hasn’t worked out that way. The more hawkish the Fed has got over the past six months, the flatter the curve has become. This probably reflects, in part, the fact that interest rates policy remains the Fed’s primary policy lever. There is also a timing argument. Balance sheet reduction is likely to be phased in over the second half of this year, making its impact three to six months away, an eternity in financial markets.

This brings us to our main point. Central banks have a much better track record of influencing short-end interest rates, even in the age of Quantitative Easing (QE). Whether a more hawkish central bank translates into higher long-end rates depends in large part on market optimism that the economy can withstand higher rates. This may be less of a concern in the US than in the Eurozone but the energy crisis has chipped away at confidence in central banks’ ability to raise rates for long, hence the flat or inverted yield curves.

We’re probably closer to the end of the adjustment higher in rates than to its start

In our view, we’re probably closer to the end of the adjustment higher in rates than to its start. In the near term, rates are on an upward trajectory and we think the odds of US Treasuries overshooting our 2.25% forecast are good. The same goes for 10Y German Bund rising above our year-end forecast of 0.60%. In the medium term however, the front-loaded path signalled by central banks and implied by financial markets should also limit long-end rates’ ability to rise much further.