What is the Terminal Rate and Why Does it Matter?
What is the Terminal Rate and Why Does It Matter?
When looking at what’s going on in the world of interest rates, it’s pretty easy to get lost in the different terms central bankers and financial media use.
Tapering, pivot, neutral rate, fed funds target range, quantitative tightening…
They don’t make it easy to understand!
But something that has become more and more key as we have gone through this (seriously) rapid rate hike cycle that started at the beginning of 2022 is where the peak in interest rates in the US will be.
This is known as the terminal rate, and we are approaching it…
Maybe.
In the chart above, you can see where the market is pricing for the peak in US interest rates to be - about 5% in May with a slightly outside chance of the peak extending to 5.25% in June.
And what matters most is the change in that outside chance of the extra 25 basis points for June being more and more priced in.
If that were to happen based on the macro data, the market might start to feel like risk is most certainly off once again (stocks fall).
This is because for the last 3-4 months, the terminal rate has changed only slightly around the 5% mark, meaning the market has gotten comfortable with this data being priced into the future path of asset prices.
Any deviation, even minor, from this would be trouble, especially if the general context sours, such as if geo-political risk enters the fray (as it has over the weekend with the reports of the drone strikes in Iran).
Interest rates are effectively the barometer of the opportunity cost of holding one asset vs another so if the rate of interest is expected to increase, you can bet the market thinks it’s effectively not worth holding onto riskier assets (like tech stocks).
So if you hear the phrase ‘higher for longer’, what we really have to translate this to is ‘investors will think risk assets are more expensive to hold and so will buy less of them until it’s safe to resume buying again (which we will come onto in the next idea we post!)’.
But what, right now, could influence whether the terminal rate stays at 5% for May or gets pushed back or higher?
Enter the 3m10y chart.
This shows the spread between the US 3 month treasury bill yield and the US 10 year treasury note yield.
And right now, it is signifying that growth 2 years out (the 3m10y curve is also called the ‘public sector yield curve’) is looking rather glum, based on historical data on forecasted GDP growth from the curve structure.
This is obviously a natural phenomenon after the Fed raised rates at the front end of the curve so rapidly in 2022, but the concerning aspect is recession tends to come when the curve reverts back towards positive territory again… and it’s currently about 35bps off the January low.
What does this mean then?
Well, it could be that the Fed is going to focus more on the yield curve and how it behaves over the next few months, purely because they are 100% aware of the implications of a reversion-post-inversion yield curve: recession.
Whilst Powell pleased the markets with a more doveish tone in his press conference last night, the statement released by the Fed was very hawkish. The Fed maintained that “ongoing increases in the target range will be appropriate” to bring price pressures under control.
If the Fed is completely adamant that inflation has to get down to 2% again then this could imply the terminal rate extends beyond 5%, even if not reflected currently in market pricing.
For this to occur, there will likely have to be more strong positive prints in NFP numbers and for PCE inflation to remain elevated. It’s a tough ask, but the structural changes in the inflation backdrop and dynamic could cause this type of mess to unfold, which is naturally painful for most portfolios.
The biggest risk that we can see from a situation like this, though, is the left tail of the price distribution curve comes into play.
This is where liquidity gets extremely thin and we see 3 standard deviation negative moves, which tend to precede recessions, and end up breaking the normal distribution of asset price returns (they end up happening many times more than predicted by a normal distribution of values).
We hope this doesn’t happen, but we must start preparing for these times where the market feels stressed, because the Fed is currently not there to support with monetary liquidity!
Good luck and always remain aware!
When looking at what’s going on in the world of interest rates, it’s pretty easy to get lost in the different terms central bankers and financial media use.
Tapering, pivot, neutral rate, fed funds target range, quantitative tightening…
They don’t make it easy to understand!
But something that has become more and more key as we have gone through this (seriously) rapid rate hike cycle that started at the beginning of 2022 is where the peak in interest rates in the US will be.
This is known as the terminal rate, and we are approaching it…
Maybe.
In the chart above, you can see where the market is pricing for the peak in US interest rates to be - about 5% in May with a slightly outside chance of the peak extending to 5.25% in June.
And what matters most is the change in that outside chance of the extra 25 basis points for June being more and more priced in.
If that were to happen based on the macro data, the market might start to feel like risk is most certainly off once again (stocks fall).
This is because for the last 3-4 months, the terminal rate has changed only slightly around the 5% mark, meaning the market has gotten comfortable with this data being priced into the future path of asset prices.
Any deviation, even minor, from this would be trouble, especially if the general context sours, such as if geo-political risk enters the fray (as it has over the weekend with the reports of the drone strikes in Iran).
Interest rates are effectively the barometer of the opportunity cost of holding one asset vs another so if the rate of interest is expected to increase, you can bet the market thinks it’s effectively not worth holding onto riskier assets (like tech stocks).
So if you hear the phrase ‘higher for longer’, what we really have to translate this to is ‘investors will think risk assets are more expensive to hold and so will buy less of them until it’s safe to resume buying again (which we will come onto in the next idea we post!)’.
But what, right now, could influence whether the terminal rate stays at 5% for May or gets pushed back or higher?
Enter the 3m10y chart.
This shows the spread between the US 3 month treasury bill yield and the US 10 year treasury note yield.
And right now, it is signifying that growth 2 years out (the 3m10y curve is also called the ‘public sector yield curve’) is looking rather glum, based on historical data on forecasted GDP growth from the curve structure.
This is obviously a natural phenomenon after the Fed raised rates at the front end of the curve so rapidly in 2022, but the concerning aspect is recession tends to come when the curve reverts back towards positive territory again… and it’s currently about 35bps off the January low.
What does this mean then?
Well, it could be that the Fed is going to focus more on the yield curve and how it behaves over the next few months, purely because they are 100% aware of the implications of a reversion-post-inversion yield curve: recession.
Whilst Powell pleased the markets with a more doveish tone in his press conference last night, the statement released by the Fed was very hawkish. The Fed maintained that “ongoing increases in the target range will be appropriate” to bring price pressures under control.
If the Fed is completely adamant that inflation has to get down to 2% again then this could imply the terminal rate extends beyond 5%, even if not reflected currently in market pricing.
For this to occur, there will likely have to be more strong positive prints in NFP numbers and for PCE inflation to remain elevated. It’s a tough ask, but the structural changes in the inflation backdrop and dynamic could cause this type of mess to unfold, which is naturally painful for most portfolios.
The biggest risk that we can see from a situation like this, though, is the left tail of the price distribution curve comes into play.
This is where liquidity gets extremely thin and we see 3 standard deviation negative moves, which tend to precede recessions, and end up breaking the normal distribution of asset price returns (they end up happening many times more than predicted by a normal distribution of values).
We hope this doesn’t happen, but we must start preparing for these times where the market feels stressed, because the Fed is currently not there to support with monetary liquidity!
Good luck and always remain aware!
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