As optimism grows amongst investors that a rally in U.S. Treasuries is imminent, a key indicator within the bond market is sending a troubling signal to anyone considering getting in.
First, the excellent news. With the halfway point of 2024 in sight, government bonds on the edge to recoup their losses for the yr as there are finally signs that inflation and the labor market are literally cooling. Traders are actually betting that this could possibly be enough for the Federal Reserve to begin cutting rates of interest as early as September.
However, the central bank’s ability to chop rates of interest could also be limited, thus representing a headwind for bonds. This is the growing view within the markets that the so-called neutral rate of interest – a theoretical level of borrowing costs that neither stimulates nor slows growth – is way higher than policymakers currently project.
“The significance is that when the economy inevitably slows, there will be fewer rate cuts and rates could be higher in the next decade or so than they have been in the last decade,” said Troy Ludtka, senior U.S. economist at SMBC Nikko Securities America, Inc.
Futures contracts based on the subsequent five years’ five-year rate – an indicator of the market’s view of how U.S. rates of interest might move – are stagnant at 3.6 percent. While that is down from last yr’s peak of 4.5 percent, it’s still greater than a percentage point higher than the common over the past decade and above the Fed’s own estimate of two.75 percent.
This is very important since it means the market is pricing in a significantly higher yield floor. The practical implication is that there are potential limits to how far bonds can rise. This must be a priority for investors preparing for an epic bond rally that got here to their rescue late last yr.
Currently, investor sentiment is improving. A Bloomberg indicator of U.S. Treasury yields recorded a decline of just 0.3 percent in 2024 on Friday, after losing as much as 3.4 percent at its lowest point through the yr. Benchmark yields have fallen by about half a percentage point since their annual high in April.
In the previous few trading days, traders have been coping with Contrary bets They are benefiting from the increased likelihood that the Fed will cut rates of interest as early as July and from demand for futures contracts, which suggests a rally within the bond market.
However, if the market is true that the neutral rate – which can’t be observed in real time since it is subject to too many influences – has risen permanently, then the Fed’s current benchmark rate of over 5% might not be as restrictive as perceived. In fact, a Bloomberg index suggests that financial conditions are relatively loose.
“We’ve only seen a relatively gradual slowdown in economic growth, and that would suggest that the neutral rate is significantly higher,” said Bob Elliott, CEO and chief investment officer at Unlimited Funds Inc. Given the present economic situation and the limited risk premiums priced into long-dated bonds, “cash looks more attractive than bonds,” he added.
The true level of the neutral rate of interest, also often called the R-Star, has grow to be the topic of heated debate. Reasons for a possible increase, which might mean a reversal of the decades-long downward trend, include the expectation of high and prolonged budget deficits and increased investment within the fight against climate change.
Further gains in bonds could require a more pronounced slowdown in inflation and growth to prompt faster and deeper rate cuts than the Fed is currently planning. The next neutral rate would make that scenario less likely.
Economists expect next week’s data to indicate that the Fed’s preferred gauge of underlying inflation slowed to 2.6% on an annualized basis last month from 2.8%. While that is the lowest reading since March 2021, it’s still above the Fed’s 2% inflation goal. And the unemployment rate has been at or below 4% for greater than two years – the very best showing because the Sixties.
“While we see that parts of households and businesses are suffering from higher interest rates, overall we have clearly managed the situation very well as a system,” said Phoebe White, head of U.S. inflation strategy at JPMorgan Chase & Co.
Financial market developments also suggest that the Fed’s policy might not be restrictive enough. The S&P 500 is hitting record highs almost each day, despite the fact that inflation-adjusted shorter-term rates of interest, which Fed Chairman Jerome Powell uses as an indicator of the impact of Fed policy, have risen by almost 6 percentage points since 2022.
“There is a market that has proven incredibly resilient in the face of higher real yields,” said Jerome Schneider, head of short-term portfolio management and financing at Pacific Investment Management Co.
With the exception of some Fed officials akin to Governor Christopher Waller, most policymakers are inclined to favor higher neutral rates. However, their estimates varied widely between 2.4% and three.75%, underscoring the uncertainties in making the forecasts.
In his talks with reporters on June 12 following the central banks’ two-day meeting, Powell appeared to downplay its importance for Fed decision-making, saying “we can’t really know” whether neutral rates have been raised or not.
For some available in the market, that is nothing latest. It is a brand new, higher reality. And it’s a possible obstacle to a rally.
