How High Will Interest Rates Rise?

Just how strong is the U.S. economy heading into this next leg of the business cycle? 

Lately, bond investors haven’t seemed so confident, pointing to potentially weaker growth ahead, as the Federal Reserve winds down the massive stimulus measures it introduced at the start of the pandemic in 2020. Since the Fed’s recent acknowledgement that high inflation may not be transitory, as it had initially thought, the bond market has priced in the central bank’s tapering its asset purchases faster and hiking interest rates sooner than previously forecast.

At the same time, investors have set an uncharacteristically low estimate for where the Fed’s rate hikes will ultimately top out—at 2%. In other words, markets seem to think the U.S. economy may not be able to cope with any rate increases beyond that level. This expected end point for rate hikes, or the “terminal rate,” is down 50 basis points from earlier this year, not to mention 160 basis points behind last cycle’s terminal rate. The lower forecast indicates the market is now pricing in the possibility that faster tightening could cut the recovery short.

Our assessment is somewhat different: We do expect tightening to start earlier, as shown in a recently revised forecast by Ellen Zentner, Morgan Stanley’s chief U.S. economist. However, we are more optimistic about the U.S. economy’s growth potential and estimate a terminal rate of 2.5%. Why this more upbeat view? 

First, as inflation cools, the Fed will likely be more patient in tightening monetary policy than current consensus indicates. We disagree with the market’s view that the Fed, which was deemed at risk of being “behind the curve” until just recently, may now be at risk of tightening too much (i.e., beyond the 2% terminal rate). Instead, we believe inflation is poised to slow from today’s record levels, as supply chains mend and demand for goods moderates in favor of demand for services. Strength for the U.S. dollar stemming from policy divergence with the European Central Bank and the People’s Bank of China, both of which are likely to stay on easier policy, could also mean downward pressure on commodity prices. In addition, it’s also likely to be some time before the Fed sees higher labor-market participation in the 25-54 age group, which otherwise might warrant more aggressive tightening.

Second, positive structural developments could drive further demand and economic growth, supporting a higher terminal rate. As we noted in our 2022 outlook, these trends include: 

• a strong capital-spending cycle catalyzed by new disruptive technologies and pandemic-related digitization of services businesses;

• more-progressive views in Washington, D.C., toward infrastructure and clean energy-related spending, which could sustain fiscal spending;

• a shift in demographics in which Baby Boomers’ excess savings give way to robust consumption by Millennials and Gen Z, especially around housing; and

• a combination of ample lending capacity at well-capitalized U.S. banks and the strongest household balance sheets in 40 years.

Ultimately, the implication for investors of higher-than-expected terminal rates is lower stock valuations, with a somewhat steeper yield curve. This means equity-market leadership is likely to broaden from high-flying tech names toward value-style and cyclical stocks, which we believe are best accessed through active stock-picking. Investors should pay attention to this week’s Fed announcement for more clarity on the potential path of interest rates. And consider rebalancing away from long-duration securities and rate-sensitive names toward quality cyclical value stocks at reasonable valuations.

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from Dec 13, 2021, “Terminal Blues.” Ask your Morgan Stanley Financial Advisor for a copy. Listen to the audiocast based on this report.