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Terminal rate: what’s the big story?

It’s a term that’s much heard these days, as markets try to forecast the shape of the current cycle of interest rates. And crucially to predict the peak rate for the cycle. But why does this peak or terminal rate matter? We consider where we are along the journey and remind ourselves of the predictive power of the bond markets.

As inflation soared to multi decade highs this year, central banks have scrambled to get ‘ahead of the curve’. Interest rates, which started the year at rock bottom levels, have been hiked aggressively, in an attempt to restrain demand and squash inflation down again. So when do central banks decide that enough is enough?

The US Federal Reserve (Fed) is keen to push expectations of a peak in rates well into 2023. And even then, the Fed is insisting that rates will stay ‘higher for longer’. But what will that peak rate be? It’s an important question for corporations and individuals looking to make major investments, such as the purchase of a property. It’s also of great interest to financial markets.

As recently as July the Fed’s view of ‘moderately restrictive’ policy pointed to a terminal rate of just over 3%. But some forecasters are now looking for a peak around 5%. Why the big jump? It largely comes down to their expectations of elevated or ‘sticky’ inflation over the next few years. Although it’s worth noting that US Treasury bond yields, often credited with predicting the path of interest rates, have fallen sharply from the year’s high point.

The fact is that none of us can see into the future, only make educated guesses. As 2022 demonstrated so clearly, much will become known over the next months that is unknowable now. And what happens once the terminal rate is reached? By definition the terminal rate marks the ‘pivot’ when central banks will switch to cutting interest rates instead. All other things being equal, as we reach that point markets should breathe a huge sigh of relief.