There are reasons to believe that US growth will accelerate to 3.5% or higher in the coming quarters. Firstly, the fiscal drag that hampered the economy during much of 2013 is easing. In addition, signs are increasing that businesses are becoming more confident about the future; they may well be willing to employ more staff and increase investment. In recent years, consumer balance sheets have also improved markedly. This is boosting purchasing power and consumer confidence.

However, at the end of 2013, the Fed assumed that growth in the second half of 2013 would reach levels between 2% and 2.5% and that it would speed up to 2.8% throughout 2014. If so, US unemployment would be high for the foreseeable future and capacity utilisation in the business sector would be low.

This is why the Fed was determined not to put obstacles in the way of growth until the jobless rate had dropped to levels where pay increases soar and capacity utilisation does not create bottlenecks for production (that is when inflation hovers into view). The Fed believed this would not happen until 2016 although it was keenly aware of the growing risks attached to quantitative easing (QE).

Source: Thomson Reuters Datastream/ECR

Moreover, the Fed itself has admitted – through its vice chairman William C. Dudley – that it does not really know what the impact of QE is on the economy. This is quite a predicament; seeing as the central bank has by now poured around $3,000 billion into the system. As widely publicised, the Fed announced it would start to taper in December 2013. In fact, this boils down to the start of monetary tightening.

The central bank is offsetting this move with the policy of forward guidance; it has ‘promised’ not to raise the short-term interest rate in the years to come. The central bank hoped that this would suffice to keep short rates – and also long rates – as low as possible until inflation risks appear on the horizon. However, as inflation is minimal, currently the Fed is more wary of deflation.

High growth queers the pitch

However, this approach is quickly being superseded. Once growth exceeds 3.5%, combined with short-term interest rates near zero and a ten-year yield around 3%, borrowing becomes very attractive. Under these conditions, an upward spiral of more lending and higher growth begins. If interest rates are low, this will stimulate credit supply, and so on. Such a ‘virtuous cycle’ will cause the money multiplier and money velocity to accelerate. If this happens, as the jobless rate and reserve capacity decline, before long, inflation risks would rise sharply.

Too little, too late

In theory, the Fed should be well able to control rising inflation. It only needs to remove the money from the system that it has created in the past years. Yet, this time such an operation will involve stupendous amounts of money. If we consider the enormous price rises (in the stock, bond and property markets) that have resulted from the recent liquidity creation of the past period, we dread to think what could happen if money is removed abruptly. There is a high chance that asset prices will plunge until – as in 2007 – a credit crisis erupts and a deep economic recession sets in.

Source: Thomson Reuters Datastream/ECR

In view of this risk, investors will fear that the Fed will do too little, too late. If so, they will price in rising inflation. We think this is the most pressing risk in 2014 once the US economy begins to grow faster than expected. Hypothetically, the Fed could respond by firmly keeping its foot on the gas (some economists believe that higher inflation is desirable as it would become easier to tackle the debt mountains).

Yet the result would be that first the bond market and later the other financial markets would go haywire as they discount swiftly rising inflation. This would be very dangerous to the economy. Interest rates would spiral out of control – an extremely unpleasant prospect when debts are sky high.

A likelier option is that the Fed will take its foot off the accelerator at a very early stage. It could even apply the monetary brakes. Hopefully, this will result in a gradual ‘brake path’ and limited price drops. Nonetheless, in this case too we could see a period of substantial market pullbacks.

Inflation expectations the driving factor

Of course, it is imperative that the Fed responds in a timely and proportional manner. If growth exceeds projections, the central bank will take its cues from the inflation expectations and financial market signals such as the difference between the nominal yields on ten-year US Treasury Bonds and ten-year TIPS. At the time of writing, the scope of this gap is around 2.25%-2.3%. As soon as it tops 2.5% – which could occur sooner rather than later and will probably go hand in hand with additional indications that inflation expectations are rising – the Fed will have to intervene. To clamp down on inflation expectations, it will need to tighten its policy until economic growth slows to 2%. Around this rate the risk of inflation will disappear.

Outlook for long-term interest rates

In the coming period, we expect bond yields to consolidate on weaker US data. We expect the yield on ten-year US Treasury Bonds to climb to 3.25% by the end of Q1 and at the end of Q2 to 3.5%. Subsequently, it could even reach levels near 4%. We suspect that the markets will too easily assume that the short-term interest rate will stay low for a long period of time.

Without a doubt, the yields on many European ten-year government bonds will follow a similar pattern. Bond markets are a system of communicating vessels and a rise in US yields pushes up bond yields in many other markets outside the US.

For the yield on ten-year German government bonds we expect at the same time downward pressure as the ECB must consider further monetary easing as a result of slow growth and mounting debt in the weaker EMU-countries. Furthermore, we anticipate rising tensions in the EMU in the course of this year (see also our regular reports on European interest rates). All in all, the yield on ten-year German government bonds could climb to 2.25% and eventually to 2.5% later this year.

The Bank of England is already facing the same dilemma that we expect for the Fed later this year. The growth outlook for the British economy is being continually adjusted upward, in response to surprisingly good figures. The British growth outlook has now improved so far that virtually no-one believes in the Bank of England’s forward guidance any more. As British inflation is already fairly high, we expect upward pressure on the yield on ten-year British government bonds as well.

We should bear in mind, though, that there are negative aspects to the higher growth of the British economy. After all, growth is chiefly being generated by extra consumer spending based on more loans. In view of the already high debt positions of many of the British, this is not necessarily a good thing. Moreover, as UK growth remains dependent on growing debts, the upward pressure on British interest rates will soon start to affect growth to some extent. This is why we think ten-year British interest rates will not rise much further than 3.75% this year.