The Real Economy

U.S. economic outlook: Interest rates

Dec 05, 2023

Key takeaways

The United States has reached a cyclical peak in rates. 

We expect the Federal Reserve to reduce the policy rate by 100 basis points by the end of the year.

We are forecasting a rate of 4.5% in the 10-year Treasury.

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Our economic forecast for 2024 implies that the United States has reached the cyclical rate peak and that a modest easing over the next 12 months is likely.

We expect the Federal Reserve to reduce the policy rate by 100 basis points to a range between 4.25% and 4.5% by the end of the year and down to 3% and 3.5% by the end of 2025. We are forecasting a rate of 4.5% in the 10-year Treasury, which compares favorably with forward dollar swaps markets pricing at a 4.4% rate in 12 months. 

Longer-term interest rates are the present value of short-term rates plus compensation for the risk of holding those long-term securities to maturity—the so-called term premium. The Fed’s setting of its overnight policy rate drives the bond market and, in turn, the willingness to borrow or lend and the level of demand and economic activity.

When the policy rate was at zero, bond yields were compressed across all maturities. There was negligible risk in borrowing or lending as 10-year yields traded below 2% during the recovery from the financial crisis and below 1% during the health crisis. 

With the cost of capital compressed at near zero, that implied that the predominant risk in the bond market was the risk of economic collapse and deflation. That risk is characterized by the decline and negative values of the term premium from 2009 until the government’s capital infusion during the pandemic.

More recently, the yield on the benchmark 10-year Treasury bond has continued to respond to the perceived changes in Fed policy. With the federal funds rate at 5.5% and far off the lower bound of zero, a wider range of trading and risk associated with bond trading exists. 

That increase has pushed the term premium above zero for the first time since 2021, which is a healthy sign for the bond market and an economy able to support higher interest rates.

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Because of structural changes in the American economy, we think 3% represents a new floor in the policy rate.

Long-term interest rates should settle between 4.5% and 5%, with the risk of modestly higher rates going forward and implying a bond yield rate near 6%. We think this implies 30-year fixed mortgage rates hovering between 5.5% and 6%, with builders buying down mortgages to address affordability issues among potential buyers.

Already in November, homebuilders were buying down mortgages on new home purchases between 4.5% and 5.5%, and we would not be surprised to see that range become the sweet spot for purchases.

Long-term yields are less likely to move above 5% because of the growing demand for consistent and safe returns of buy-and-hold strategies in the bond market. The domestic demand for Treasurys and higher-yielding U.S. corporate bonds will be augmented by the demand for U.S. securities by foreign investors who seek safe-haven investments augmented by the currency return of a strong dollar relative to their domestic currency.

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