The danger of the Fed’s presumed US exceptionalism: real yields, “illusory alpha”, declining neutral rates and the need for core “received” positions.

The US interest rate market is maintaining longer-term path to lower trading ranges in terms of yields. This is under-pinned by a lower “neutral” real Fed Funds rate. It also reflects an underlying weakness in the US economy, which reduces the resilience of the expansion to domestic and external shocks and which also questions the Fed’s presumed exceptionalism – it’s view that it can tighten policy while the rest of the world is looking to ease. Indeed, despite yet another ratcheting lower of it’s presumed path of policy tightening at its June FOMC meeting, the Fed still appears overly optimistic on the path of rate hikes. Once the Brexit-related gyrations in global risk premia have passed, the underlying trend of lower yields in term-US interest rates is expected to continue. Investors will continue to be rewarded for retaining core “received” positions. Meanwhile, one trend which is supporting the declining trend in UST and US IRS yields – falling real yields – is also serving to preclude a source of “illusory” alpha which benefitted the asset management industry pre-crisis, and which is now supporting the rise of lower cost passive investment strategies.

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