How long can high rates last? Bond markets say maybe forever

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, Bloomberg reports.

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. Benchmark yields slipped 1 basis point as trading resumed in London on Monday.

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 per cent. While that’s down from last year’s peak of 4.5 per cent, 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 per cent.

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 per cent in 2024 as of Friday after having lost as much as 3.4 per cent for the year at its low point. Benchmark yields are down about half a percentage point from their year-to-date peak in April.

Traders in recent sessions have been loading up on contrarian bets that stand to benefit from greater odds the Fed will cut interest rates as soon as July, and demand for futures contracts that would benefit from a rally in the bond market is booming.

But if the market is right that the neutral rate -- which cannot be observed in real time because it’s subject to too many forces -- has permanently climbed, then theFed’s current benchmark rate of more than 5.0 per cent may be not as restrictive as perceived. Indeed, a Bloomberg gauge suggests financial conditions are relatively easy.

“We’ve only seen fairly gradual slowing of the economic growth, and that would suggest the neutral rate is meaningfully higher,” said Bob Elliott, CEO and chief investment officer at Unlimited Funds Inc. With the current economic conditions and limited risk premiums priced into long-maturity bonds, “cash looks more compelling than bonds do,” he added.

The true level of the neutral rate, or R-Star as it is also known, has become the subject of hot debate. Reasons for a possible upward shift, which would mark a reversal from a decades-long downward drift, include expectations for large and protracted government budget deficits and increased investment for battling climate change.

Further gains in bonds may require a more pronounced slowdown in inflation and growth to prompt interest rate cuts more quickly and deeply than the Fed currently envisions. A higher neutral rate would make this scenario less likely.

Economists expect data next week will show that the Fed’s preferred gauge of underlying inflation slowed to an annualized rate 2.6 per cent last month from 2.8 per cent.