SINGAPORE (April 19): Borrowers should brace themselves for a significant shift in the global interest rate environment in the next few years.

The Fed Funds rate is likely to normalise at 3.5% by 2020, far higher than current market expectations. US 10-year bond yields will rise to over 4%.

That’s according to Fitch Ratings in its “Unnatural Real Interest Rates” research report which was published today.

Among several competing theories, Fitch says the most convincing explanation for the collapse of US real interest rates reflects a highly elongated credit and monetary policy cycle.

Loose US monetary policy in the mid-2000s was followed by excess credit creation by banks driving down real rates and culminating in the subprime crisis.

The economic consequences of the crash necessitated exceptionally loose monetary policy in response, perpetuating the cyclical downward pressure on rates.

“The BIS is a major proponent of this view and Fitch believes it has significant intuitive appeal,” says the ratings agency.

With these elongated cyclical forces having now largely played out, real interest rates are likely to return to something closer to US growth potential of 2%.

Barring renewed deflationary shocks, this implies big shifts in nominal interest rates in the next few years.

Still, Fitch says “lower for longer” view on interest rates has become deeply embedded in expectations.

Among the other less convincing theories Fitch dealt with, another is largely predicated on a view that “equilibrium” real interest rates in the US have fallen to very low levels, barely above zero.

Given the Fed’s inflation target of 2%, this helps justify medium-term expectations of nominal interest rates of little over 2%.

While the fall in long-term US GDP growth potential does justify lower real interest rates compared to historical norms, rates have fallen by more than can be explained by the deterioration in long-term growth prospects.

The research explains the additional fall in rates as a result of structural changes that have permanently increased saving and reduced investment in the economy.

As a higher supply of savings has met with weaker demand for funds, the relative price of savings –  i.e. the real interest rate – has fallen. This is a perfectly sensible framework, but supporting evidence on saving and investment shifts is less robust.

A rising share of working-age people, increasing inequality and an emerging-market savings glut are claimed to have increased the supply of savings.

However, the US national saving rate has actually declined as the share of the working population has increased, says Fitch, while the impact of inequality is unlikely to have been significant.

Emerging-market current account surpluses do imply a net outflow flow of capital, but US  financial linkages are much stronger with other advanced countries, it adds.

Meanwhile, Fitch says shifts in risk premiums may simply be the result of QE policies that have distorted “risk free” rates relative to broader borrowing costs.

Rising risk premiums for private-sector borrowers (i.e. over government rates), falls in the relative price of capital goods and lower public investment are seen as factors driving down investment demand.

But relative capital goods prices levelled off from the mid-2000s, while public investment rates may now start to rise again.

Private-sector rates of return on capital have also been steady.