Interest rates around the world have risen quite dramatically over the past two weeks. The rise in yields seems in stark contrast to a number of factors: weak GDP data in the U.S., ongoing monetary policy easing by many developed market central banks, and a growing consensus that the Federal Reserve will be exceptionally patient in the timing of the liftoff from the zero bound and slow in the pace of monetary policy tightening.
That said, there are still long-term forces at work that augur for continued global economic recovery and, eventually, higher rates. These include the reduction in left-tail risk in Europe and the Greek situation stabilizing at least for now; increasing inflationary pressures from both the rebound in energy and metals prices and growing evidence of incipient wage pressure, both of which are captured in the rising breakeven inflation rate on inflation-linked bonds; and the combination of ongoing improvement in labor market conditions, stability and recovery in commodity prices and stability in the dollar, all of which make a Fed rate hike inevitable.
Two critical factors often overlooked in fundamental reasoning for market prices are valuation and initial conditions. This is where a framework can enable investors to look past the short-term market noise when making investment decisions.
Using the market’s implied two-year swap rate five years forward, one can create a valuation tool that takes into account the expected intermediate inflation rate, a fair value for real short-term interest rates and a term premium.
Investors can assume their own expectations for the variables, but using a 2% inflation expectation, the expected New Neutral real short-term interest rates of 0.0%–0.5% and a term premium of 0.75%, fair value on the two-year rate five years from now is about 2.75% to 3.25%.
As shown in the graph below, the current market pricing for this rate is about 2.75%, so the market has reversed from clearly overvalued to near the bottom of the fair value range.
Markets are always likely to overshoot in either direction, but a framework of this nature can help explain market movements and guide decision-making.
Read our recent posts “TIPS Prove to Win Out Over Recent Deflation Fears” and “What the Fed Is Watching.”