Chart of the Week: Will rates really stay higher for longer?

Long-term interest rates, both real and nominal, have risen dramatically across the major economies since late 2021. In the case of the UK, around half of the decline in long-term interest rates that had taken place over the past two to three decades has unwound in the space of two years. Does this mean we have entered a new paradigm? Have we moved from a world of ‘lower for longer’ to one of ‘higher for longer’, where to paraphrase Bank of England Chief Economist Huw Pill, the policy rate of interest will trace out a path that looks more like Table Mountain than the Matterhorn? We are far from convinced. As we show in our chart, in terms of timing, the increase in long-term interest rates has closely coincided with the increase in short-term interest rates, as measured by the two-year OIS spot rate. Moreover, one can trace the point at which both short- and long-term rates turned a corner, not just in the UK but in other major economies, back to late 2021 when US Federal Reserve Chair Jerome Powell decided that it was probably a good time to ditch the word ‘transitory’ as a description of the pick-up in inflation seen up to that point. In our view, the increase in long-term interest rates reflects a higher term premium, rather than a fundamental reassessment of the equilibrium real rate of interest. Uncertainty about the outlook for inflation, and for interest rates, means investors now require greater compensation to lend to governments, or indeed to anyone, in the long term. In Fathom’s central scenario, increased uncertainty fades over the coming year or two and long-term interest rates fall much further than is currently priced in.

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The views expressed in this article are the views of the author, not necessarily those of LSEG.

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