July 20, 2024

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Fed rates may not be slowing the economy much—but cuts may not go that low

2 min read

Just as optimism is growing among investors that a rally in US Treasuries is about to take off, one key indicator in the bond market is flashing a worrying sign for anyone thinking about piling in.

First, the good news. With 2024’s midway point in sight, Treasuries are on the cusp of erasing their losses for the year as signs finally emerge that inflation and the labor market are both truly cooling. Traders are now betting that may be enough for the Federal Reserve to start cutting interest rates as soon as September.

But potentially limiting the central bank’s ability to cut and thus setting up a headwind for bonds is the growing view in markets that the economy’s so-called neutral rate — a theoretical level of borrowing costs that neither stimulates nor slows growth — is much higher than policymakers are currently projecting. 

“The significance is that when the economy inevitably decelerates, there will be fewer rate cuts and interest rates over the next ten years or so could be higher than they were over the last ten years,” said Troy Ludtka, senior US economist at SMBC Nikko Securities America, Inc.

Forward contracts referencing the five-year interest rate in the next five years — a proxy for the market’s view of where US rates might end up — have stalled at 3.6%. While that’s down from last year’s peak of 4.5%, it’s still more than one full percentage higher than the average over the past decade and above the Fed’s own estimate of 2.75%. 

This matters because it means the market is pricing in a much more elevated floor for yields. The practical implication is that there are potential limits to how far bonds can run. This should be a concern for investors gearing up for the kind of epic bond rally that rescued them late last year.

For now, the mood among investors is growing more and more upbeat. A Bloomberg gauge of Treasury returns was down just 0.3% in 2024 as of Friday after having lost as much as 3.4%…

Liz Capo McCormick, Ye Xie, Bloomberg

2024-06-23 19:41:40

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