As investors grow increasingly optimistic about a potential rally in US Treasuries, a key indicator in the bond market is signaling caution.
As we approach mid-2024, Treasuries are close to recovering their losses for the year. Signs are emerging that inflation is easing, and the labor market is cooling, prompting traders to speculate that the Federal Reserve might start cutting interest rates by September. Benchmark yields fell by 1 basis point when trading resumed in London on Monday.
However, there’s a potential challenge. The Federal Reserve’s ability to reduce rates may be constrained by a rising market belief that the economy’s neutral rate—a theoretical borrowing cost level that neither accelerates nor slows growth—is higher than current estimates.
“The implication is that with inevitable economic slowdowns, we could see fewer rate cuts, leading to higher interest rates over the next decade compared to the past ten years,” explained Troy Ludtka, senior US economist at SMBC Nikko Securities America, Inc.
Market Sentiment
Forward contracts referencing the five-year interest rate in the next five years—seen as a proxy for market views on US rates—are stalled at 3.6%. While down from last year’s peak of 4.5%, this is still above the Fed’s estimate of 2.75%.
This indicates that the market is pricing in a higher floor for yields, suggesting potential limits to how far bonds can rally. This could be a concern for investors hoping for a repeat of last year’s bond rally.
Currently, investor sentiment remains positive. A Bloomberg gauge of Treasury returns was down just 0.3% in 2024 as of Friday, recovering from a loss of 3.4% earlier in the year. Benchmark yields are down about half a percentage point from their year-to-date peak in April.
Traders have been betting on the possibility that the Fed will cut interest rates as early as July, leading to increased demand for futures contracts that would benefit from a bond market rally.
Impact of a Higher Neutral Rate
If the neutral rate has indeed risen, the Fed’s current benchmark rate of over 5% may not be as restrictive as assumed. A Bloomberg gauge suggests financial conditions are relatively easy. Bob Elliott, CEO and chief investment officer at Unlimited Funds Inc., noted that the gradual economic slowdown suggests the neutral rate is meaningfully higher. “Cash looks more compelling than bonds do,” he added, given current conditions and the limited risk premiums priced into long-term bonds.
The true level of the neutral rate, or R-Star, is highly debated. Factors like large government budget deficits and increased climate change investment could push it higher, reversing a decades-long downward trend.
For further bond gains, a more significant slowdown in inflation and growth is needed to prompt quicker and deeper rate cuts than the Fed currently envisions. A higher neutral rate would make this scenario less likely.Economists expect upcoming data to show a slowdown in underlying inflation to an annualized rate of 2.6% from 2.8% last month, still above the Fed’s 2% target. The unemployment rate remains low, at or below 4% for over two years, the best performance since the 1960s.
Phoebe White, head of US inflation strategy at JPMorgan Chase & Co., commented, “While we do see pockets of both households and businesses suffering from higher rates, overall as a system, we clearly have handled it very well.”
Market Performance
Financial markets also suggest the Fed’s policy may not be restrictive enough, with the S&P 500 hitting records despite shorter maturity inflation-adjusted rates surging since 2022. Jerome Schneider, head of short-term portfolio management and funding at Pacific Investment Management Co., noted, “The market has been incredibly resilient in the face of higher real yields.”
