(Bloomberg) — As investors grow optimistic that a rally in U.S. Treasuries is on the way, one key bond market gauge is showing worrying signs for anyone thinking about adding to their holdings.
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First, the good news: With the 2024 midpoint in sight, signs that both inflation and the labor market are truly cooling are finally emerging, and Treasuries are poised to erase this year’s losses. Traders are now betting that that could be enough of a sign for the Federal Reserve to start cutting interest rates as early as September.
But a growing view in the market that the economy’s so-called neutral interest rate – the theoretical level of borrowing costs that neither stimulates nor slows growth – is much higher than policymakers currently expect, limiting central banks’ ability to cut rates and potentially posing a headwind for bonds.
“The bottom line is that as the economy inevitably slows, there will be fewer rate cuts and interest rates over the next decade or so could be higher than they have been over the past decade,” said Troy Rudka, senior U.S. economist at SMBC Nikko Securities America.
Futures contracts priced at five-year interest rates over the next five years — a proxy for market expectations of where U.S. interest rates will be — are stuck at 3.6%, down from a peak of 4.5% last year but still more than 1% higher than the average over the past decade and above the Fed’s own forecast of 2.75%.
This is important because it means the market is setting a much higher floor for yields. The practical implication is that there is a potential limit to how far bond prices can rise. This should be of concern to investors who are bracing for the kind of epic bond rally that rescued them late last year.
For now, investor mood is growing increasingly optimistic. The Bloomberg gauge of Treasury yields was down just 0.3% on 2024 as of Friday after falling 3.4% to its lowest point this year. The benchmark yield is down about 0.5% from its year-to-date high in April.
Traders have been pouring money into contrarian bets in recent sessions on the growing likelihood that the Fed will cut interest rates as soon as July and on a surge in bond market gains.
But if the market’s view that the neutral interest rate (which is subject to many forces and cannot be observed in real time) is permanently rising is correct, then the Fed’s current benchmark interest rate above 5% may not be as restrictive as perceived. Indeed, Bloomberg’s index suggests that financial conditions are relatively easy.
“The slowdown in economic growth is only moderate, suggesting a much higher neutral interest rate,” said Bob Elliott, CEO and chief investment officer at Unlimited Funds Inc. The current economic situation and the limited risk premium priced into long-term bonds “makes cash look more attractive than bonds,” he added.
The true level of the neutral rate, also known as R-Star, is the subject of intense debate. Reasons for a possible rise that would mark a reversal of a decades-long downward trend include the prospect of longer government budget deficits and increased investment in tackling climate change.
Further increases in bond prices would require a more significant slowdown in inflation and growth, which could prompt the Fed to cut interest rates faster and deeper than it currently envisions. A higher neutral rate would make this scenario less likely.
Economists expect data released next week to show the Fed’s preferred underlying inflation rate slowed to 2.6% from last month’s 2.8% annual rate, the lowest since March 2021 but above the Fed’s 2% inflation target. And the unemployment rate has remained below 4% for more than two years, its best performance since the 1960s.
“While certainly both households and businesses are feeling the effects of rising interest rates, the system as a whole is clearly handling the situation very well,” said Phoebe White, head of U.S. inflation strategy at JPMorgan Chase & Co.
Financial market movements also suggest the Fed may not be tightening policy enough: The S&P 500 is setting new records almost daily even as short-term inflation-adjusted interest rates, which Fed Chairman Jerome Powell has cited as a gauge of the impact of Fed policy, are rising by nearly 6 percentage points since 2022.
“Despite rising real yields, the market has been surprisingly resilient,” said Jerome Schneider, head of short-term portfolio management and capital raising at Pacific Investment Management.
Bloomberg strategists say…
“With just a few dot plots, the Fed raised its estimate of the nominal neutral rate from 2.50% to 2.80%, indicating that central banks around the world are still trying to figure out the scale of economic expansion and inflation they will see this cycle. As such, current market assessments that expect the Fed to make nearly two across-the-board rate cuts this year appear overstated.”
— Ben Lamb, Cross-Asset Strategist
Most policymakers, with the exception of some Fed officials such as Governor Christopher Waller, are leaning toward raising the neutral rate, but their projections range from 2.4% to 3.75%, highlighting the uncertainty in making those projections.
During a discussion with reporters on June 12 after the end of the central bank’s two-day policy meeting, Powell said he “actually doesn’t know” whether the neutral rate had risen, appearing to downplay its importance in the Fed’s decision-making.
For some in the market, this is not unknown: It’s a new, higher reality that could pose a roadblock to stocks moving higher.
What to see
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Economic data:
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June 24: Dallas Fed Manufacturing Activity
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June 25: Philadelphia Fed Non-Manufacturing Index, Chicago Fed National Business Conditions Index, FHFA Home Price Index, S&P CoreLogic, The Conference Board Consumer Sentiment Index, Richmond Fed Manufacturing and Business Conditions, Dallas Fed Services Index.
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June 26: MBA mortgage application, new home sales
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June 27: Leading goods trade balance, Q1 GDP (3rd), wholesale and retail inventories, unemployment claims, durable goods, home sales forecast, Kansas City Fed manufacturing
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June 28: Personal Income and Expenditures, PCE Deflator, MNI Chicago PMI, University of Michigan Business Sentiment (final), Kansas City Fed Service
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Fed Calendar:
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June 24: Federal Reserve Bank President Christopher Waller and San Francisco Federal Reserve Bank President Mary Daly
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June 25: Federal Reserve Governor Michelle Bowman and Federal Reserve Governor Lisa Cook
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June 28: Richmond Fed President Thomas Barkin and Bowman
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Auction Calendar:
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June 24th: Invoices for weeks 13 and 26
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June 25: 42-day CMB, 2-year bond,
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June 26: 2-year FRNs resumed, 17-week Treasury notes, 5-year Treasury notes
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June 27: 4-week, 8-week, 7-year Treasury bills
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