{"id":54923,"date":"2016-07-28T00:05:38","date_gmt":"2016-07-27T22:05:38","guid":{"rendered":"http:\/\/beta.next-finance.net\/opinion\/interest-rates-brexit-and-term-premiums\/"},"modified":"2019-12-31T01:00:41","modified_gmt":"2019-12-31T00:00:41","slug":"interest-rates-brexit-and-term-premiums","status":"publish","type":"post","link":"http:\/\/beta.next-finance.net\/en\/opinion\/interest-rates-brexit-and-term-premiums\/","title":{"rendered":"Interest rates: Brexit and term premiums"},"content":{"rendered":"

Since the announcement of the vote for Brexit at the UK referendum, long-term interest
\nrates have plunged to record lows across all major currencies. The US 10-year interest rate
\nhit an all-time low of 1.32% on July 6, before rebounding to 1.47% on July 12. But are
\nthese levels sustainable?<\/p>\n

It is instructive to analyze long-term interest rates movements by breaking them down to identify
\nthree factors: expected real short-term interest rate, inflation expectations and the term premium.<\/p>\n

A long-term bond can be arbitraged for a short-term deposit that is rolled over for the bond’s entire
\nmaturity, so the nominal long-term interest rate can be analyzed as the expected short-term
\ninterest rate discounted over the long term. Accordingly, the 10-year interest rate appears as the
\naverage value of the expected overnight interest rate over the next 10 years, plus a risk premium
\nthat takes into account the fact that the capital invested in the case of a long-term bond can be
\nreleased onto the market before maturity only at the cost of a potential discount \u2013 the price of the
\nlong-term bond in the secondary market is subject to interest rate risk. On the bond market, this
\nrisk premium is known as the term premium. This average expected short-term interest rate can
\nitself be broken down into a real short-term interest rate and projected future inflation, according
\nto Fisher’s equation. These three factors, expected real short-term interest rate, inflation
\nexpectations and the term premium, are presented in the chart below for the US 10-year interest
\nrate. We use the calculations of economists Kim and Wright, as published by the US
\nFederal Reserve, for the term premium and the expected nominal short-term interest rate. The
\ncalculation of the term premium is derived from a modelling process that extracts the information
\non expectations of future short-term interest rates across the entire yield curve.<\/p>\n

Breakdown of US long-term interest rates<\/strong><\/p>\n

This breakdown indicates
\nthat the fall in long-term
\ninterest rates can
\nprimarily be attributed to
\nthe drop in the expected
\nreal short-term interest
\nrate and in the term
\npremium, while 10-year
\nexpected inflation, which
\nis approximated by the
\n10-year inflation swap in
\nthis case, remains
\nvirtually stable.<\/p>\n

\"breakdown_of_us_long-term_interest_rates.jpg\"<\/a><\/p>\n

The market is actually
\npricing in a scenario
\nwhereby a normalization
\nof the Fed’s interest rates is impossible, even in the long term. The expected average real shortterm
\ninterest rate has fallen to 0.36%. By way of comparison, the Fed\u2019s median scenario
\n(“Summary of Economic projections<\/em>” of June 15) expects a long-term equilibrium value of the Fed
\nFunds rate at 3%. If we take into account its medium-term inflation target of 2%, this is therefore
\nequivalent to a real short-term interest rate of 1%. Admittedly, the interest rate that the Fed
\nexpects has fallen markedly since these projections started in 2012, but it still remains well above
\nthe figure that the market now expects. The market is therefore showing the Fed that it is set to
\nfail in its efforts: investors expect that monetary policy normalization will turn out to be impossible.<\/p>\n

Future maturities of the key interest rate<\/strong><\/p>\n

According to our estimates, the
\nterm premium stands at -0.6%. As shown by the
\nchart below, this term premium is
\nnot yet at its historical low, which
\nwas reached during the Fed\u2019s
\nquantitative easing programs in
\n2012. However, our term premium
\nmodelling approach indicates that
\nthis extremely negative figure is
\njustified by several factors: the
\ndegree of political uncertainty, as
\nmeasured by the Baker, Bloom &
\nDavis indicator; the flight to
\nquality, as assessed by the
\nvaluation of other safe havens
\nsuch as the Swiss franc and
\nprecious metals; the level of
\nexcess dollar supply, as reflected
\nby US banks’ excess reserves; and
\nthe pressure on the market for long-term financing in dollars (EUR\/USD basis swaps). <\/p>\n

\"future_maturities_of_the_key_interest_rate.jpg\"<\/a><\/p>\n

US: 10 years term premium<\/strong><\/p>\n

Beyond the increase in the
\npost-Brexit political uncertainty,
\nthis shock has prompted a
\nslight downward revision of
\nexpectations for global growth,
\nbut the most salient point in
\nour opinion is that it has
\nrevealed market complacency
\nin its assessment of political
\nrisks. The obvious failure of
\npolitical analysts, pollsters and
\nonline betting sites to
\naccurately forecast the result
\nof the UK referendum showed
\nthat the markets largely
\nunderestimated the cost of
\npolitical uncertainty. This
\n“repricing<\/em>” should now affect
\nall forthcoming election results,
\nin Europe as well as in the
\nUnited States.<\/p>\n

\"us_-_10_years_term_premium.jpg\"<\/a><\/p>\n

Furthermore, we would also add another factor that is set to put downward pressure on the term
\npremium, i.e. the increasingly negative impact of long-term interest rates in Europe (Germany,
\nSwitzerland, etc.) and in Japan. This trend is forcing domestic institutional investors to search for
\nyield in markets that are still liquid and provide positive yields, such as the US Treasuries market.
\nIn this more uncertain post-Brexit world, capital that is fleeing risk will continue to find a safe
\nhaven in the liquidity of US bonds. We therefore continue to favor this market in our asset
\nallocation to hedge our positions on global equities.