The high interest rate signal released by the bond market: the long-term neutral interest rate will be at 3.6%

Recent expectations of interest rate cuts have been on the rise, but a key bond market indicator is sounding the alarm for investors.

As inflation gradually falls, bond traders are starting to bet on the Federal Reserve cutting rates in September, with some even predicting that the rate cut could come as early as July. At the same time, market expectations for the long-term neutral rate R* are also being revised upwards.

According to related data, the current market forecast for the 5-year, 5-year forward rate is 3.6%, a full 1 percentage point higher than the average level of the past 10 years, and higher than the Federal Reserve's median forecast for the long-term neutral rate of 2.75%, indicating that the market believes future interest rates will remain elevated.

Some media analysis points out that factors driving the increase in the long-term neutral rate may include massive fiscal deficits, climate change, economic growth rates, bond risk premiums, etc., suggesting that the potential upside for U.S. bonds may be limited, or may impose constraints on the Fed's room for rate cuts.

Troy Ludtka, Senior U.S. Economist at SMBC Nikko Securities America, stated:

"This indicator suggests that as the economy inevitably slows down, the number of rate cuts will decrease, and interest rates over the next decade may exceed those of the past decade."

In fact, the Federal Reserve is also shifting towards a higher long-term neutral rate camp. Jerome Schneider, Head of Short-Term Portfolio Management and Financing at Pacific Asset Management, stated: In just a few dot plots, the Fed has raised its expected nominal neutral rate from 2.5% to 2.8%.

Therefore, the current interest rate level above 5% may not necessarily be very "restrictive": the S&P 500 index has hit record highs this year, indicating that the financial markets are still active. While inflation has significantly cooled down, the labor market continues to show strong resilience.

Phoebe White, Head of U.S. Inflation Strategy at Morgan Stanley, said:

"Although households and businesses have been affected by the high interest rate environment, overall, we seem to be handling it quite well."

Economists predict that the May PCE price index, to be released this Friday, will show a year-on-year growth rate slowing to 2.6%, the lowest level since March 2021