Fixed Income  

How high could US interest rates go?

From May – when the Federal Reserve announced its intention to reduce its quantitative easing programme – to the start of September, yields on 10-year US government bonds increased from 1.66 per cent to almost 3 per cent.

They are currently at roughly 2.6 per cent. This shows the market continues to anticipate a tightening of monetary policy. Early indicators suggest that the Fed will resume tapering at the end of 2013 or beginning of 2014.

Readings above 50 of the PMI composite index, which measures the sentiment of purchasing managers in industry, indicate expansion: the index is currently at a healthy 55.7 points. Accordingly, US government bond yields decreased only modestly after the recent Fed meeting.

How high could US interest rates go? Economic theory suggests that long-term savers expect to participate adequately in real growth and be compensated for inflation. If, as expected, real growth reaches 3 per cent in the coming year and the core inflation rate (excluding food and energy) is just less than 2 per cent, the yield on 10-year US bonds should rise in the next year from 2.6 per cent before levelling off at roughly 3.7 per cent.

As the era of record-low policy rates draws to a close, yields should increase for shorter maturities: yields on two-year US government bonds could increase as well, from 0.52 per cent to 1.5 per cent, and the interest rate curve should flatten somewhat in the coming year.

In contrast to the US, interest rates are unlikely to change much in the eurozone. Although the economy should rebound in the single currency area in the coming year, growth is likely to remain weak.

The base case is for yields on 10-year German Bunds to increase only slightly in the next 12 months, from 1.9 per cent to 2.5 per cent. Similarly, yields on two-year German bonds are expected to rise modestly, from 0.26 per cent to approximately 0.45 per cent in the same period.

As in Europe, weak growth in Japan is mitigating against an interest rate increase. At its recent committee meeting, the Bank of Japan confirmed that it will leave its quantitative easing policy unchanged.

Its continued bond purchases should further inflate Japan‘s monetary base by ¥60trn (£381bn) to ¥70trn per year. Yields on 10-year government bonds should increase from 0.75 per cent to 1.25 per cent, and on two-year bonds from 0.12 per cent to 0.20 per cent. Although interest rates have risen, they are low in real terms. This makes it necessary to seek alternatives to government debt.

In industrialised countries, the appeal of corporate bonds has been boosted by resurgent economies and improving credit quality. In the US, bonds issued in connection with mergers and acquisitions are in the spotlight.

In Europe, the focus has been on a few companies with materially deteriorating business profiles. Overall, market participants are acting cautiously after the sharp interest rate movements of previous months. The growing supply of corporate bonds is an additional burden.

Asoka Woehrmann and Randy Brown are co-chief investment officers at Deutsche Asset & Wealth Management