Wall Street's views on neutral interest rates are increasingly divergent, and the outlook for Federal Reserve policy is uncertain

According to the Zhitong Finance APP, Wall Street has differing views on the neutral interest rate, reflecting the uncertainty surrounding the benchmark interest rate level in the current economic environment. The neutral interest rate, which is the ideal rate level that neither stimulates nor suppresses economic growth, has become elusive in the current complex and changing economic backdrop. Greg Peters, Co-Chief Investment Officer of PGIM Fixed Income, which manages over $800 billion in assets, emphasizes this point with his statement, "No one knows what neutral is."

There is a significant disparity in predictions of the neutral interest rate between Wall Street and the Federal Reserve, ranging from 2.4% to 4.5%. This divergence has led to differing expectations among investors regarding the Federal Reserve's easing cycle, with uncertainty about whether this cycle has just begun or is about to end. The release of economic data, especially those indicating economic resilience or weakness, has caused sharp fluctuations in bond yields, increasing market instability.

Due to the uncertainty surrounding the neutral interest rate, risks in the bond market have increased, and misjudgments could lead to substantial losses. For example, betting on a neutral interest rate below 3% implies expectations that the Federal Reserve will further cut rates, making bonds with current yields slightly above 4% appear attractive. However, if the Federal Reserve has actually completed its rate cuts, the bond positions accumulated around the current yields could suffer losses.

Peters adopts a cautious strategy, acknowledging, like others on Wall Street, that it is impossible to accurately know the specific value of the neutral interest rate. Therefore, his plan is to sell U.S. Treasuries when the 10-year Treasury yield falls to 3.5% and to buy when the yield rises to 4.5%.

Figure 1

For a long time, the market has generally believed that the neutral interest rate is relatively low, with it commonly thought to hover around 2.5% after the 2008 financial crisis. However, the COVID-19 pandemic disrupted this consensus, and the surge in inflation has not been as temporary as Federal Reserve policymakers claimed, nor has the economic recovery been short-lived. Despite the Federal Reserve rapidly raising rates in 2022 and 2023, inflation and economic growth remain high due to the massive fiscal and monetary stimulus injected into the financial system.

With the expansion of the U.S. budget deficit and the gradual establishment of global trade barriers, the rise of the neutral interest rate has become a consensus among most, although there is still fierce debate over the specific magnitude of the increase. This divergence is not only widespread on Wall Street but is also frequently discussed in Federal Reserve meetings.

Currently, Federal Reserve policymakers estimate the range for long-term interest rates (seen as a representation of the neutral interest rate) from 2.375% to 3.75%, the largest range in over a decade. The market generally expects the Federal Reserve to lower the benchmark interest rate by a quarter percentage point to a range of 4.25% to 4.5% at the upcoming meeting.

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Figure 2

Outside of the Federal Reserve, the estimated range for the neutral interest rate is larger, varying from 2.7% to 4.6%, which is actually close to the current benchmark rate. This wide range of predictions and the uncertainty surrounding the neutral interest rate have led some investors to avoid making bold decisions and opt for more cautious investment strategies.

Investors Diverge on Federal Reserve Policy Direction and Neutral Interest Rate Predictions

In the current economic environment, there is a significant divergence among investors regarding the Federal Reserve's policy direction and predictions for the neutral interest rate. Felipe Villarroel, a portfolio manager at TwentyFour Asset Management, avoids holding short-term bonds to protect his investments from adverse data releases.

Thomas Kennedy, chief investment strategist at JP Morgan Private Bank, advises clients to reduce portfolio risk due to the uncertainty surrounding the Federal Reserve's policy direction. He emphasizes that investors should respect the potential for multiple outcomes and avoid excessive risk.

Meanwhile, some market participants maintain their neutral interest rate predictions, hoping to deliver substantial returns for their clients.

Max Kettner, chief multi-asset strategist at HSBC Global Research, believes that the current market volatility is precisely what some investors are looking for, especially following a prolonged period of ultra-low interest rates.

Henry McVey, a partner at KKR & Co., has adopted a clear strategy: selling long-term bonds, buying cash, and investing in assets that are more attractive in a high neutral interest rate environment, such as infrastructure or real estate.

Strategists at Deutsche Bank expect the neutral interest rate to stabilize around 4%, predicting that the yield on 10-year Treasury bonds will reach approximately 4.65% by the end of the year. In contrast, fund managers at TCW Group Inc. believe that the pandemic has little impact on the neutral interest rate and continue to hold U.S. Treasuries with maturities of two to five years, anticipating a slowdown in the U.S. economy and further rate cuts by the Federal Reserve.

Bret Barker, co-head of global rates at TCW, states that they still view a neutral interest rate of 2.5% as a key indicator. These differing views and strategies reflect the current market's uncertainty and divergence regarding the direction of interest rates, necessitating careful consideration of various potential economic and policy scenarios by investors when making investment decisions