A swift reassessment of how high the Federal Reserve will raise interest rates this year has rocked the bond market in recent weeks. Now, the market faces a bigger threat: the growing notion that rates will stay elevated even after the US central bank’s inflation fight is all over.
Upside surprises in January employment, inflation and retail sales data are fueling both conversations simultaneously. While a higher peak for rates now seems almost certain, the economy’s resilience in the face of almost a year’s worth of aggressive tightening is also increasingly raising doubts over whether the level of rates which can be considered “neutral” for growth is really as low as it used to be.
Fed officials have so far maintained that neutral is still around 2.5% — the same as before the pandemic began — and they would probably be expected to return there once inflation is beaten. Any revision of that view would threaten to push yields on longer-term Treasury securities to fresh new highs in 2023.
“Our thought is that markets, and perhaps Fed policymakers, don’t have the right number for the long-run rate,” said Praveen Korapaty, the chief interest-rates strategist at Goldman Sachs Group Inc. in New York. “The labor market continues to be strong. That is going to be a big deterrent to the Fed actually easing aggressively.”
The central bank has in the span of 11 months raised its benchmark federal funds rate from nearly zero to above 4.5%, and now seems poised to take it as high as 5.3% by midyear, according to prices of overnight index swaps. It hasn’t been above 5% since 2007.
Back then, the neutral rate was also presumed to be much higher — around 4% — and the 10-year Treasury yield traded between 4.5% and 5%. In the years following the financial crisis, estimates of the neutral rate slid to 2.5% as investors and policymakers became pessimistic about the economy’s long-term growth prospects.
Anchoring Bonds
That has helped anchor the Fed’s outlook for interest rates — officials see the federal funds rate reverting to about 4% by the end of next year and around 3% by the end of 2025, according to quarterly projections last updated in December — and bolstered buyers of long-duration Treasuries, even after the 10-year yield briefly rose above 4% late last year.
But broader acceptance of the idea that the neutral rate — known in economics circles as “r-star” — has gone up would have adverse implications for a Treasury market nursing back-to-back down years. A higher neutral rate should raise yields across the curve, led by rising short-term rates along with some restoration of a term premium for owning longer-dated Treasuries.
“The 2 percentage point drop in estimates of r* following the global financial crisis rests on shaky ground,” Matthew Raskin, the head of US rates strategy at Deutsche Bank Securities in New York, wrote in a Feb. 10 note. “If growth and the labor market remain resilient,” then investors can expect Fed officials to upgrade their estimates, which “would have big implications for longer-run rates,” he said.
Estimating the neutral rate is more art than science, but the Fed spends plenty of time trying to figure it out, and some of its models are showing an increase. One of them, maintained by the Richmond Fed, now has it at about 1.3% on an inflation-adjusted basis, up from around 0.5% in 2016. That would translate to a rise in the nominal neutral rate to 3.3% from 2.5%.
The central bank will publish a fresh set of projections at its next policy meeting in March, but policymakers may be reluctant to jolt the bond market with upgrades to their official r-star estimates so soon, according to Gargi Chaudhuri, the head of iShares investment strategy for the Americas at BlackRock in New York.
And even if the estimates were to go up, Fed Chair Jerome Powell would probably try to downplay the development, she said.
“The last 12 months of labor market strength is not enough to call for a higher neutral rate,” Chaudhuri said. “It could well be that 2.75%, 3% is the right level. We don’t know quite yet.”
Changing Relationships
Part of the problem relates to uncertainty over the lag time between policy tightening and the impact it has on the economy, as well as how the unusual experience of the pandemic may be affecting it. For many bond investors, that raises questions about how much stock to put into any estimates.
“R-star is a very theoretical concept, and I think it’s really a question of interest-rate sensitivity and the long and variable lags associated with tightening,” said John Madziyire, a fixed income portfolio manager at The Vanguard Group in Malvern, Pennsylvania.
“Interest rate sensitivity is much lower” at the moment because homeowners and companies locked in low borrowing costs before rates began rising last year, Madziyire said. “So, all these rate hikes potentially haven’t really impacted the economy.”
Moreover, a recession later this year or in 2024 as tight monetary policy does finally start to bite — a scenario most forecasters are still calling for, even if so far it’s been delayed — would only prolong the guessing game about the true neutral rate.
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