By Yoruk Bahceli

(Reuters) – The market rallies despite the fact that bets about rising interest rates have not been canceled by belief in U.S. Federal Reserve policy tightening.

The market’s reaction to the massive rate hikes that the Fed, Bank of England, and other institutions have priced in for next year has been a bit softer due to COVID-linked uncertainty. Jerome Powell, Fed boss, has indicated that he plans to raise rates many times within the next two year.

Rate rise talk has not had an impact on stock markets. Equity funds saw inflows almost every week of this year. Investors claim that there are no alternatives in an environment where inflation-adjusted bonds yield below 0%.

These negative “real” yields are combined with stubbornly low government borrowing costs over a longer period, flattening yield curves, and skyrocketing equities all depend on the belief that terminal rates, or central bank policy rate peaks, will be lower than previous cycles.

In 2018, the previous Fed rate increase cycle reached a peak of 2.25%-2.5%. According to the euro-dollar futures view of U.S. rate in five years (a proxy for the final rate), the next cycle will see the Fed’s last rate hike peak at 2.25%-2.5% in 2018.

The Fed project a 2.5% bet. This is because it believes that Fed policy tightening will end before the Fed’s inflation target of 2%. The “real” U.S. rate of interest will continue to be negative.

Similar results can be seen in Britain’s euro zone, where terminal rates hover just above and below 1%.

According to Craig Inches (head of rates at Royal London Asset Management), “What the equity markets are saying is that… real yields won’t go very high” and interest rates will not rise much.”

“Bond markets have said that…we will keep long-end yields high because (rates), we think, will rise then go straight back down.”

Title: Eurodollar futures rate hike bets, https://tmsnrt.rs/3xH4kd0

However, there’s no margin of error.

Global stocks have seen a trillion dollars pour into them this year, more than in the previous 19 years. This has pushed share prices to new heights. While corporate bond risk premia have been historically low, cumulative household, corporate, and sovereign debt soared to $36 trillion in the wake of the pandemic, they are still very low.

Real U.S. Yields are currently at less than 1% on the 10-year benchmark. Many think this will continue for several years, or even decades. The yields on longer-dated bonds remain low – the 10-year Treasuries hit just 1.8% in this year’s peak.

Barnaby Martin from BofA’s credit strategy, stated that “what’s driving the longer portion of the curve” is the expectation that central banks will not be able raise rates as high as they did in previous hiking cycles.

TIGHTROPE

The natural rate or neutral rate (sometimes referred to as r-star) is crucial in estimating the final rate. It’s the level at which full employment can co-exist with stable inflation.

This has happened in steady decline throughout the developing world. Reasons range from ageing populations to high savings rates and the United States is no exception, with the inflation-adjusted r* falling to around 0.4% last year, from 2.5% in 2007.

Title: U.S. neutral rate or r* has been in decline U.S. neutral rate or r* has been in decline, https://tmsnrt.rs/3pgxLyQ

There is a risk that neutral rates will turn out to be higher than what the markets expect.

Some argue that long bond yields are misleading indicators because they have been suppressed due to huge demand for safer securities.

Second, the Fed is pricing aggressively in rate rises relative to its projections suggests that investors aren’t buying the Fed switching to flexible inflation targeting (FAIT). FAIT allows the Fed to aim for inflation of 2% in the long-term and allow temporary overshoots.

Guneet Dihinggra Morgan Stanley (NYSE: )The head of U.S. rate strategy noted that the Fed intended to increase its neutral rate in the new inflation strategy.

Dhingra claimed that “to the extent you are able to call the FAIT framework effective, you can also claim the Fed has succeeded in raising the neutral rate higher then the last cycle.” He predicted that the terminal rate might rise above 2.5%.

As a result, rates could rise through increased corporate spending and productivity. Economists will be watching the NAIRU Rate – which is the lowest level of unemployment without increasing inflation.

It is not clear if the NAIRU’s years-long slide will be reversed by the pandemic, or if workers have more bargaining power.

Title: NAIRU rate, https://tmsnrt.rs/3pkTC8j

Although there is not yet any sign of a wage-spiral, current labor shortages could pose challenges to the market’s final rate bets.

The Fed may also be more inclined to keep its current rate-hike cycle if there is less demand.

Ludovic Colin is the portfolio manager for Vontobel Asset Management.

They will need to walk a tightrope if they want equities and their current valuation to survive.

Title: Fed dot plot, https://tmsnrt.rs/3pkTC8j