Luke Bartholomew and Liam O’Donnell take a closer look at the implications of the significant sell-off in market interest rates since the start of the year.
Insurers are particularly keen observers of interest rate movements because their business can be affected by rates in a number of ways.

For a start, insurers invest largely in interest rate-sensitive assets because there’s a need to match interest rate-sensitive liabilities to help protect their business. And, in turn, protects their policyholders as the risk of insolvency driven by rate movements is reduced.

Insurers may feel comforted by the resilience of their balance sheet when assets and liabilities are well matched. However, they’re still exposed to interest rate movements in other ways.

For example, insurers will care about rates given the direct consequences they have for investment income, ie are opportunities to increase investment income presented? On the liability side, a change in interest rates might affect how competitively a firm can price its insurance policies, or may impact on the cost of long-dated claims, which can be prevalent in the books of both life and property and casualty insurers.

Insurers’ investment portfolios are rarely risk free. Changes in interest rates may have a knock-on impact to the valuation of risk assets on the insurer’s balance sheet. Additionally, insurers want to understand the reason behind the changes in interest rates. For example, if the changes are driven by differing inflation assumptions, and what this tells insurers about the impact on the cost of future claims.

So insurers care about rates for a whole host of reasons. What can they make of the recent sell-off in market interest rates?

Putting the recent market moves in context

The scale of the sell-off in market interest rates since the start of the year has raised questions about the extent to which this is consistent with central bank policy. It has also raised questions about whether the negative spill-over effect of rising yields on other risk assets will cause an undesirable tightening in financial conditions that central banks will be forced to counter.

One interpretation of the sell-off is that it’s an endogenous repricing of the growth and inflation outlook. Also, that it’s consistent with the Federal Reserve’s objectives in light of the ongoing vaccine roll-out and the expectation of easier fiscal policy following the Democrat victories in the Georgia Senate run-offs.

To understand this, it’s important to examine the drivers behind the interest rate market. US yields bottomed in August last year. Since then, yields have mostly increased at the longer end of the curve (10 year), while the very short end (2 year) has been much more stable. This has delivered a clear steepening in the 2s-10s curve (see Chart 1).

What’s clear is that term premia – the compensation investors demand for holding a longer duration asset – have increased over this period. This could be related to decreased risk aversion as the Covid-19 crisis eases, meaning that investors are less keen to hold safe assets such as government bonds. Or that investors have become less concerned about disinflationary tail risks than they were given changing economic fundamentals.

Chart 1: US bond yields – long end sell-off has driven the curve steepening

For illustration only. The value of clients’ investments can go down as well as up and may be worth less than was paid in. Information is based on Aberdeen Standard Investments’ understanding in March 2021.

It could also be down to a higher inflation risk premium given the scale of fiscal stimulus efforts. Indeed, the increase in nominal yields at the long end has mostly been driven by higher inflation expectations, with breakeven rates rising. These breakevens should tell us about market expectations for inflation over the full 10-year period. However, they tend to be correlated with moves in transitory inflation and in energy prices particularly.

This combination of rising inflation expectations and low, short-term bond yields over the second half of last year:

  • kept real interest rates low
  • supported the recovery
  • reflected a policy path in line with the Federal Reserve’s average inflation target (AIT).

Now, better vaccine and virus news combined with the large anticipated boost from the forthcoming fiscal stimulus have pushed US growth and inflation expectations higher, causing the curve to steepen. However, because the Federal Reserve is committed to allowing inflation to overshoot its 2 per cent target for a period of time under its new AIT framework, it means short-term interest rates remain low and accommodative.

The position of the Federal Reserve

In his Humphrey-Hawkins Congressional testimony, Federal Reserve Chair Powell highlighted this benign interpretation of events. During the testimony, he struck a sanguine tone about the sell-off, suggesting it was good to see the market price in a higher growth outlook. And following his testimony, his comments may have opened the door for the sharp additional spike in yields.

While there’s merit to this version of events, it’s not consistent with the full contours of the more recent market move. Strikingly, as the sell-off progressed, front end rates were also dragged higher and inflation expectations were unchanged, implying a rise in real rates. This can be seen in the ‘belly’ of the curve, with the 5-year real rate increasing, as the market-implied forecast for the first interest rate hike moved to early 2023. This is earlier than our forecast for the first hike – in the second half of 2023, well after tapering starts in 2022 - and earlier than we think the Federal Reserve would be comfortable with the current market pricing.

Strikingly, as the sell-off progressed, front end rates were also dragged higher and inflation expectations were unchanged, implying a rise in real rates.

Chart 2: Recent increase in real rates is a warning sign for the Federal Reserve

For illustration only. The value of clients’ investments can go down as well as up and may be worth less than was paid in. Information is based on Aberdeen Standard Investments’ understanding in March 2021.

This front end sell-off may have been driven in part by market positioning playing the asymmetry of risks around rates at the lower bound, with a limit to how far front end rates can fall from here. However, there’s scope for a much larger sell-off if the Federal Reserve has to engage in a more aggressive tightening cycle to get on top of an inflationary overshoot.

Through this lens, the move in short rates looks less like a repricing of the growth and inflation outlook, and more like either:

  • the market questioning the credibility of the Federal Reserve’s AIT framework, with it contemplating the risk that the Federal Reserve will move to tighten policy in the face of a short burst of higher inflation
  • the market demanding a higher premium for holding nominal interest rates as perceptions about the risk of higher inflation grow.

Both these drivers may explain the hit to risk assets during the latest rise in yields. A rising risk of a policy error would naturally create negative spill-overs to other financial assets. Otherwise, the implied increase in the discount rate and broader rate structure would affect expected earnings and valuations. The Federal Reserve cares about the full constellation of financial asset prices rather than just short-term interest rates. Therefore, any market move which sees real rates move significantly higher; or the front end reprice; or a large tightening of financial conditions will concern the Federal Reserve much more than just inflation breakeven and long rates moving higher. And it’s this that will eventually provoke a policy response.

Options for the Federal Reserve

For now, the Federal Reserve is likely to push back on the repricing of front end rates through communication rather than direct policy moves. This is likely to involve stressing to market participants about its commitment to AIT and how it’s comfortable with an economy that’s running hot. The Federal Reserve may also reiterate the sequencing around tapering and rate hikes, and the gap that’s likely to occur between the end of tapering and the start of rate hikes.

While the latter form of communication depends on calendar-based guidance rather than the Federal Reserve’s preferred state contingent guidance (which stresses the state of the economy in determining policy moves), reminding the market that the tapering process is likely to take at least a year may be a good way of pushing back on the market, bringing forward the pricing for the first hike.

If these verbal interventions don’t work and the sell-off in rates continues, there are likely to be four signposts from the Federal Reserve for more aggressive action:

  • It’s likely to be most concerned about a further increase in short-term rate expectations which imply a faster start to policy tightening than consistent with its AIT.
  • It’s more likely to push back on any sharp increases in real yields, especially if associated with falling inflation expectations.
  • It will be sensitive to negative spill-over effects through the rates market to other US financial assets, the dollar and global risk assets.
  • Finally, it’s likely to be uncomfortable with rapid moves or significant volatility in the rate structure. The Federal Reserve has been forced to move to loosen financial conditions in the past, in response to some or all of the above triggers.

The Federal Reserve has tools it can use to influence financial conditions and push back more forcefully. It could even introduce yield curve control to set the shape of the curve and help to avoid the front end moving higher. However, after much discussion last year, the Federal Reserve seems to have rejected this policy so it’s not likely in the near-term. It’s more likely that it decides to increase its asset purchases and target its purchases on certain longer-dated maturities.

It’s important to stress that we’re a long way from this point though.

The market outlook for the UK

In the UK, financial conditions have been tightening since the start of the year, driven by the rise in sterling and now by the global increase in interest rates. To some extent, this tightening represents an endogenous higher repricing of UK growth and inflation prospects in light of the success of vaccine roll-out and lockdown easing plans.

However, part of the reason the UK will grow more rapidly this year is that the economic contraction last year was much greater, so its output gap is bigger. Moreover, the UK will not enjoy the supportive fiscal backdrop of the US, with the recent Budget signalling a shift to tighter policy over the next few years. This is likely to weigh on the speed of the UK’s medium-term recovery, and the ability of the Bank to lift interest rates over the foreseeable future.

On top of this endogenous re-pricing, there’s been a hawkish shift in the Bank of England’s communication. Rather than pushing against the recent tightening of financial conditions, the Bank has been leaning in. After months of speculation, economic analysis and technical preparation for negative rates (which had seen the market price in negative policy rates in the UK), the Bank discarded any short-term prospect of a move to negative interest rates, with the month of August being the earliest they may be implemented. This mechanically forced short-term market rates higher, and potentially implied the Bank’s reaction, which also pushed rates upwards.

The Bank of England often pivots quite aggressively from one policy stance to the next. It may be that by allowing this tightening in financial conditions, it has to do more easing in the future to ensure the level of monetary support remains appropriate.

What the future holds

While the speed of the recent sell-off and the extent of its spill-over is probably greater than the Federal Reserve would consider optimal, it’s comfortable with much of the rise in yields as a positive signal about the state of the economy.

Front-end pricing probably has overshot, but the Federal Reserve should be able to resist this with verbal guidance. Only a more extreme move would trigger more serious intervention, especially as it would be hard to spot if the tightening in financial conditions is generating a drag in an economy which is set to grow rapidly. Indeed, the risk is that some of the damage is masked by the strong fiscal impulse and is felt more keenly as it starts to moderate in 2022.

While there’s scope for a further sell-off, there are limits to how far this can eventually go. The yield on 10-year government bonds is unlikely to settle sustainably above 2 per cent given that the long-run equilibrium rate is much lower than in the past. As the year progresses, investors will likely return their focus to the high unemployment rates and large output gaps that the pandemic has created, and this will see interest rates fall again.

There’s also a limit on how far global rates markets can diverge even in the face of different domestic fiscal policy, as global rates are pinned down by global liquidity factors, which remain abundant.

Only a radical shift to easier policy across the world would give rise to more concern about a sustained increase in global government bond yields.

Luke Bartholomew is Senior Monetary Economist at Aberdeen Standard Investments and Liam O’Donnell is Head of Nominal Rates at Aberdeen Standard Investments.

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