Fixed income and inflation expectations

To determine where central bank policy should be, it's useful to look at the Taylor Rule. It has been around for decades, but is still one of the best models for guiding monetary policy when the credibility of the central bank is at stake. Its simplicity makes it all the more useful. It argues that nominal base rates should be close to nominal GDP plus or minus a coefficient that measures how far inflation is from its target and how growth is faring relative to its long-term trend.

Fig. 1 - Tayloring US rates...

US Taylor Rule rates using core personal consumption expenditure and PCE forecast vs fed funds rate, %

Currently, the Taylor Rule suggests that the federal funds rate should be around 6.5 per cent – against the Fed's target range of 5.25-5.50 per cent. Based on consensus forecasts for 2024 and 2025, the model says the Fed’s key interest rate should be at 3.75 per cent at the end of 2025 (see Fig. 1). 

Given how much inflation has overshot central bank targets during the past couple of years, the Fed is likely to have to stick to Taylor Rule policy levels for the rest of the decade in order to shore up its inflation-fighting credibility. Assuming trend GDP growth of 2 per cent and the 2 per cent inflation target, this implies an average fed funds rate of 4 per cent for the next 5 to 7 years. By contrast, the market and the Fed expect a rate closer to 2.5 per cent.

It takes a long time for central banks to establish, or re-establish, their inflation-fighting credibility once it’s been shaken. So even if inflation returns to target by 2025 and stays there through to 2030, it will still have averaged 3 per cent during the decade – a significant overshoot of target. 

Fig. 2 - ...and the euro zone's

European Taylor Rule rates based on CPI and forecast CPI vs European Central Bank deposit rate, %

The European Central Bank is in a slightly more favourable position than the Fed. Having kept inflation close to target during the 2000s, and well below in the 2010s, the spike in consumer prices over the past couple of years is much less damaging to its inflation-fighting credibility. 

A simple Taylor rule analysis suggests that the ECB’s key deposit rate should be around 5.25 per cent now, against the actual rate of 4.0 per cent, and, based on consensus forecasts for CPI and GDP growth, would need to be at 3.7 per cent by 2025 if those forecasts are right. But given its record of undershooting the target and assuming 1 per cent growth and 2 per cent inflation, we think the ECB’s deposit rate could comfortably sit at an average of 2.5 per cent for the rest of the decade (see Fig. 2). 

In all, because they’re not sufficiently factoring in inflationary stickiness and loose fiscal policy, investors are likely to be overestimating how much central banks can ease policy and underestimating how high cash rates are likely to be in the medium and longer term. We believe that the coming cycle is likely to see rates bottom at 3 per cent in the US and 2 per cent for the ECB.

Fig. 3 - Investors adapting to inflation, US...

US average inflation relative to 2% target past decade vs average real yield during current decade, %

With central banks set to be aiming for positive real rates for a substantial period – in contrast to the decade following the financial crisis of 2008 – yield curves are likely to be, on average, flatter or inverted, rather than upward sloping as they have been during the past 30 years.

As a result, investors will have to manage the duration of their fixed income portfolios much more actively and have less of a bias for long-dated bonds. Given that traditional bond benchmarks have an inherently long bias, this implies a more benchmark agnostic approach.

Fig. 4 - ...and Europe

Euro zone average inflation relative to 2% target past decade vs average real yield during current decade, %

At the same time, investors should also expect an increase in the dispersion of returns across individual markets given central banks’  differing attitudes to inflation. For instance, the Bank of England has been much less rigorous in sticking to its 2 per cent inflation target. This suggests the UK government bond yield curve will be steeper than the US one. 

Central banks’ efforts at reconciling weak growth, sticky inflation and activist fiscal policies could well shorten interest rate cycles. They would also tend to lead to higher interest rate volatility than investors grew used to during the past two decades. At the same time, central banks’ experience with quantitative easing could see them use these alternative means of providing liquidity where financial market accidents threaten – think the Credit Suisse and Silicon Valley Bank failures – even as they keep key interest rates at positive real levels. 

And because past inflation dictates what level of real yields investors demand in the current period (the lower the inflation then, the lower the real yields expected now), the recent spike in inflation is likely to dominate investor expectations for years to come (see Figs. 3 and 4). 

Finally, the further complication of a deteriorating fiscal deficit in the US suggests bond investors need to factor in an additional risk premium. Neither Democrats nor Republicans care much about the state of the government’s finances, so there’s unlikely to be any progress in that direction following the 2024 presidential election. 

In light of sticky inflation and fiscal laxness, investors would be wise to add a 0.5 percentage point premium to what they demand from 30-year Treasury bonds above what 10-year Treasuries yield. At the same time, European investors would do well to add a small premium for the risk that the ECB will allow inflation to run slightly hot for a while, suggesting 10-year German bund yields of 3 per cent for the rest of the decade.