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Expect rate rises to come at ‘glacial pace’

Slow tightening ahead: Steven Major, HSBC's global head of fixed-income research

Don’t expect interest rates to bounce back sharply any time soon.

That’s the advice from HSBC’s global head of fixed-income research Steven Major, who expects predicts that the US Federal Reserve will not starting raising rates until December.

London-based Mr Major, who visited the Island to make a presentation to HSBC Bermuda clients, has a reputation for making accurate calls on the direction of bond yields, after being one of few experts to correctly predict that US Treasury rates would fall in 2014.

He expects the US 10-year bill to close this year with a yield of 2.5 per cent. In afternoon trading yesterday, the yield was 2.36 per cent.

US interest rates impact Bermuda in multiple ways, including bank lending rates and the profitability of Bermuda’s large insurance sector, which invests much of its pool of capital in fixed-income securities like sovereign bonds.

Mr Major’s assessment is that we should not expect big moves to happen any time soon. The road to relative normalcy after years of accommodative monetary policy since the global financial crisis in 2008 will be a long one, he predicted.

“The shifts in monetary policy will move at a glacial pace,” Mr Major said in an interview. “It’s taken seven or eight years to get here and we might be close to starting a seven- to ten-year descent.”

The US central bank, known as the Fed, is likely to be tentative in raising interest rates, despite the economic growth and job creation seen in the US, where the unemployment rate is now 5.3 per cent.

“If there is unambiguous evidence of wage inflation, then they will raise rates — but later rather than sooner,” Mr Major added.

Fed chairwoman Janet Yellen and her board would be very keen to avoid a U-turn scenario — starting to raise interest rates this year, only having to cut them again next year, he added.

That was a mistake made by Sweden’s Riksbank, which raised rates to 2 per cent in 2011 as a pre-emptive strike against the inflation it expected and by October last year, it cut the rate to zero after inflation failed to materialise.

Mr Major said history would be no guide as to what will happen next, given the unprecedented nature of the monetary policy of recent years. He anticipates a slow and unconventional policy tightening cycle, which he says has been signalled by Ms Yellen.

In a report entitled “Steeped in Pain”, published last month, Mr Major and his fixed-income team at HSBC state: “The Federal Reserve’s tightening cycle should be an unconventional one, the legacy of years of highly unconventional US monetary policy.

“Its policy rate is likely to increase slowly and remain at a very accommodative level for a prolonged time period after lift-off.”

Normally, when the Fed raises its funds rate, it leads to a flattening of the yield curve, meaning that the difference in the yield between short and longer-term duration becomes less.

However, during the upcoming tightening cycle, Mr Major expects the yield curve to steepen. ‘Term premium’ — the component of yield not fully explained by real GDP and inflation — will have a major influence, he argues.

“Based on our analysis of the links between tightening cycles and the curve slope, the two-to-ten-year curve spread is quite flat and could steepen 50 basis points to 100 basis points,” the report states. “This reflects the negative term premium in long-term yields.”

The impact of the tightening will have an impact on stocks, as well as bonds.

Mr Major advises: “If the Fed’s attempts to normalise policy produces a bout of nervousness among investors then equities could become extremely volatile. Faced with this turbulence, investors might instinctively gravitate towards safer, low beta stocks with resilient earnings.

“However, our work on equity duration suggests they should be doing exactly the opposite. If investors react to higher bond yields by becoming risk averse then we would use this as an opportunity to increase weightings in short duration equities.”

HSBC includes materials, capital goods, financials, luxury goods and IT, as short duration equities, which have a high beta and low, volatile dividend growth.