When I was in Abu Dhabi, I was on a panel for one of the breakout sessions focusing on global interest rates. And while there was a resource from Oxford Economics brought in to give a presentation, I couldn’t resist making my opinions and beliefs known since interest rates are one of my obsessions. What follows is the outline that I put together, with the help of Claude.ai, to organize my thoughts and key points I wanted to convey.
Short Rates: The Fed’s Impossible Trilemma
The Fed faces an unprecedented policy challenge navigating three conflicting imperatives:
- Growth Stabilization Against Deglobalization Headwinds
- Onshoring and friendshoring inherently reduce productive efficiency—producing domestically costs more than optimized global supply chains
- The transition period creates investment but also inflation without corresponding productivity gains
- Tariffs and trade restrictions act as supply-side shocks that simultaneously slow growth and raise prices
- The Fed may need to maintain relatively accommodative short rates to offset these growth-inhibiting forces, particularly if unemployment begins rising
- Geopolitical Risk Premium Management
- Heightened US-China tensions create tail risks that could manifest as sudden shocks (Taiwan, trade wars, financial decoupling)
- The Fed may want policy optionality—keeping rates lower than “neutral” to maintain ammunition for crisis response
- However, this collides with inflation concerns from the very same geopolitical fragmentation
- Fiscal Dominance Pressures
- Defense spending, industrial policy subsidies, and infrastructure for economic resilience all require massive fiscal outlays
- The Fed may face pressure (implicit or explicit) to keep short rates contained to manage government debt servicing costs
- This is especially acute if long rates rise substantially
My narrative: The Fed will likely try to thread the needle with short rates in the 3.0-4.0% range—high enough to maintain credibility on inflation, but not so high as to choke off the necessary capital formation for reindustrialization or trigger a debt crisis.
Long Rates: Market Pricing of Structural Inflation
The bond market has different concerns than the Fed’s dual mandate. Long rates reflect:
- Embedded Inflation Risk Premium
- Deglobalization is inherently inflationary—you’re replacing cheap Chinese labor and optimized supply chains with expensive domestic production
- The “China price” that anchored goods inflation for 30 years is disappearing
- Economic nationalism means governments prioritize security over efficiency, embedding higher structural costs
- Labor has more bargaining power in reshored industries (can’t threaten to move production abroad)
- Massive Capital Requirements Creating Crowding Out
- AI buildout requires staggering amounts of: data centers, semiconductor fabs, power generation (likely natural gas and nuclear), electrical grid upgrades, cooling infrastructure
- Simultaneously, you have: defense industrial base expansion, critical mineral processing facilities, pharmaceutical manufacturing, general reshoring
- Plus ongoing needs: aging infrastructure, energy transition investments
- This creates a structural bid for capital that keeps real rates elevated
- Fiscal Trajectory Concerns
- Defense spending rising (China containment, Ukraine precedent, Middle East instability)
- Industrial policy spending (CHIPS Act just the beginning)
- No political constituency for fiscal restraint
- Bond vigilantes may demand higher term premiums, especially if they see the Fed trapped by the trilemma above
- China’s Deflationary Export Dumping
- China’s response to internal imbalances is to export even more aggressively, subsidizing production to maintain employment
- This creates a tug-of-war: deflationary goods from Chinese overcapacity vs. inflationary Western protectionism
- The bond market likely bets protectionism wins (tariffs, quotas, anti-dumping duties), meaning the deflationary impulse gets blocked and domestic inflation wins
- This is reinforced by European and US political inability to tolerate hollowing out of industrial base
Your narrative: Long rates likely settle in the 3.75-4.50% range (10-year), potentially higher during periods of fiscal or geopolitical stress, reflecting:
- 2-2.5% structural inflation expectations (above the Fed’s comfort zone)
- 1.5-2% real rate (elevated due to capital scarcity)
- Variable term premium based on fiscal and geopolitical headline risk
The Steep Curve Thesis
This gives you 50-150 basis points of steepness (2s10s), which is steep by recent historical standards:
Why it persists:
- The Fed cuts or holds short rates to support growth through difficult transition
- Market refuses to believe inflation is truly contained given structural forces
- Capital scarcity keeps real long rates elevated
- Political pressure keeps the Fed from fully normalizing short rates even if they want to
Risks to my view:
- Recession scenario: If deglobalization + protectionism + geopolitical shock trigger hard landing, long rates could collapse faster than the Fed cuts (flattening or inversion)
- Fed credibility crisis: If inflation truly re-accelerates, Fed forced to hike short rates dramatically, potentially inverting curve again
- China crisis: A financial crisis in China could create deflationary wave that overwhelms other forces (at least temporarily)
Panel Talking Points
- “We’re exiting the great moderation era of globalization” – The 30-year regime of falling inflation, low rates, and steep curves is over
- “The Fed is increasingly trapped between growth and inflation” – Can’t fully address one without exacerbating the other
- “The bond market is pricing the return of scarcity” – Capital, energy, labor, and resources are all constrained in ways they weren’t during peak globalization
- “China’s internal contradictions are the world’s external problem” – Their overcapacity becomes our inflation via protectionism
- “A steep curve isn’t bullish—it’s the market’s skepticism” – It reflects doubt that the Fed can achieve both growth and price stability in this new regime
We are in a much different environment than the Long Emergency period of 2008-2020 when monetary policy was far more dominant than fiscal policy, there was much less political will to run large deficits as a percentage of GDP, there was less government intervention in business which optimized efficiency and a more open flow of trade and people versus focusing on resilience and national security. It’s for these reasons that I am hard pressed to see us returning to rates anywhere near where they were in the Long Emergency.
Yes, the total possible variables that the Fed may consider can be complex. But many of these factors are at a noise level that should often be ignored.
Your discussion generally seems to suggest what the Fed ought to do. However, there is a substantial level of disagreement within Fed. This impacts what they actually will do.
And interest rate policies do not have universal application. Government leaders sometimes don’t follow good logic and often make decisions that the Fed cannot impact.
The greatest current sector being impacted by interest rates is housing. A substantial rate reduction would be very helpful, but I personally doubt that the Fed will do anything soon. But Fed actions have often been erratic, so I may be wrong.
My feeling is that the Fed should be accepting likely future inflation levels at the 3%+ level as far more likely than trying to attain a 2% level (I don’t see that being possible any time soon). I agree that we are unlikely to see interest rates returning to the recently past low levels.