How long will high interest rates last? The bond market says it could be forever

Zhitong Finance APP noticed that just as investors were becoming increasingly optimistic that U.S. Treasury prices were about to rebound, a key indicator in the bond market is sending a worrying signal, making those considering buying in large quantities feel uneasy.

First, the good news. With the midpoint of 2024 just around the corner, signs of inflation and a real cooling labor market have finally emerged, putting U.S. Treasuries on the brink of erasing this year's decline. Traders are now betting that this may be enough to prompt the Fed to start cutting rates as early as September.

However, more and more people in the market believe that the so-called neutral rate - a theoretical level of borrowing costs that neither stimulates nor slows economic growth - is far higher than policymakers' current expectations, which could limit the central bank's ability to cut rates, thereby adversely affecting the bond market.

Troy Ludtka, Senior U.S. Economist at Sumitomo Mitsui Banking Corporation Nomura Securities America, said: "It is important that as the economy inevitably slows down, the number of rate cuts will decrease, and interest rates over the next decade or so may be higher than in the past decade."

The forward contract refers to the five-year five-year forward rate - the market's forecast of where U.S. rates may ultimately go - has stalled at 3.6%. While this is down from last year's peak of 4.5%, it is still more than a percentage point higher than the average level of the past 10 years, and higher than the Fed's own estimate of 2.75%.

This is important because it means that the market is digesting expectations of a much higher lower bound for yields. The actual implication is that there may be a potential limit to how far bonds can go. This should draw investors' attention as they prepare for the kind of epic bond rebound that saved them at the end of last year.

Currently, investors' sentiment is becoming more and more optimistic. As of last Friday, Bloomberg's measure of U.S. Treasury yields has only fallen by 0.3% in 2024, compared to a full-year decline of 3.4% at its low point. Benchmark bond yields have fallen by about 0.5 percentage points from the year-to-date high set in April.

In recent trading days, traders have been making reverse bets, which will benefit from the increasing likelihood of the Fed cutting rates as early as July, as well as strong demand for futures contracts for a bond market rebound.

But if the market believes that the neutral rate has been climbing, then the Fed's current benchmark rate of over 5% may not be as restrictive as people imagine. In fact, a Bloomberg indicator shows that financial conditions are relatively loose.

Bob Elliott, CEO and CIO of Unlimited Funds Inc., said: "We only see economic growth slowing down quite slowly, which may mean that the neutral rate is significantly higher." He added that given the current economic conditions and limited risk premium for long-term bond pricing, " Cash looks more attractive than bonds."

The real level of neutral interest rates (also known as R-Star) has become a hot topic of discussion. Reasons for a possible upward trend may include the expected continued significant increase in government budget deficits and increased investments to address climate change, marking a reversal of the decades-long downward trend.

Further increases in bond prices may require more pronounced slowdowns in inflation and economic growth to prompt the Federal Reserve to cut interest rates faster and deeper than currently expected. A higher neutral interest rate would make this scenario less likely.

Economists expect that data to be released next week will show that the Fed's favored potential inflation rate on an annual basis has dropped from 2.8% last month to 2.6%. Although this is the lowest level since March 2021, it still exceeds the Fed's 2% inflation target. The unemployment rate has remained at 4% or below for over two years, the best performance since the 1960s.

Phoebe White, head of inflation strategy at Morgan Stanley, said, "While we do see some households and businesses affected by rising rates, overall, we are clearly managing very well."

The performance of financial markets also indicates that the Fed's policy may not be strict enough. The S&P 500 index has touched record highs almost every day, despite short-term inflation-adjusted rates soaring nearly 6 percentage points since 2022. Fed Chair Powell stated that the inflation-adjusted rate is an indicator of the Fed's policy impact.

Jerome Schneider, head of short-term investment portfolio management and financing at Pacific Investment Management Company, said, "Faced with higher real yields, the market has indeed shown incredible resilience."

Cross-asset strategist Ven Ram said, "In several dot plots, the Fed raised its estimate of the nominal neutral interest rate from 2.50% to 2.80%, indicating that central banks around the world are still trying to control the scale of this round of economic expansion and inflation. That's why the current market expectation that the Fed will cut rates nearly twice this year seems somewhat exaggerated."

Apart from a few Fed officials like Governor Waller, most policymakers lean towards raising the neutral interest rate. However, their estimates fluctuate widely between 2.4% and 3.75%, highlighting the uncertainty of forecasts.

Following the conclusion of the two-day central bank policy meeting on June 12, Powell seemed to downplay the importance of neutral interest rates in Fed decision-making during discussions with reporters, stating, "We can't really know" whether the neutral interest rate is rising For some people in the market, this is not unknown. This is a new, higher reality