Bonds Are Hostage to an Elusive Neutral Rate That Keeps Shifting

The bond market’s re-energized bulls may want to dial down their excitement because their fortunes hinge on whether an abstract, almost elusive number, is as low as they assume.

At the heart of what’s been shaping fixed-income investors’ views this year is the so-called neutral rate, which neither stimulates nor restricts the economy. Treasury bulls began the year invigorated by the belief that the Federal Reserve’s aggressive tightening was set to push borrowing costs well above the neutral level and that officials would soon have to reverse course.

The bet was that the era of low long-term rates would return and short-dated bonds would rally even faster with central bankers set to pivot to easing before year-end.

Fast-forward to today and the 10-year yield is about where it started January, even after a rally Wednesday sparked by a report showing cooling consumer-price inflation. The yield curve, meanwhile, isn’t far from its deepest inversion in decades, and wagers on 2023 interest-rate cuts have all but vanished.

Firms including Goldman Sachs Group Inc. and TwentyFour Asset Management are taking notice. They’re warning that the neutral rate has increased and that more Fed officials will eventually acknowledge that trend, tripping up bond bulls and rewarding those who have spurned Treasuries. For Goldman Sachs, the inflation-adjusted neutral level is as much as quadruple the Fed consensus.

“People haven’t really paid attention to the long-run fed funds rate,” said Felipe Villarroel, a portfolio manager at TwentyFour Asset Management. “We think it’s about to move. It means that the scope for a rally in the 10-year Treasury is more limited as that anchor is higher.”

Average Estimate of Fed Long-Term Dot Rises