The idea that bond yields may be heading lower over the coming months is probably not a startling one for many readers at this stage of the economic cycle. In fact, serious bond houses will be focusing on trying to guess what the Fed’s ‘terminal rate’ will be once they start lowering rates this month (probably). Guesses on economic growth and inflation will be part of that process, and in a circular bit of thinking, will go into the forecasts for yields along the sovereign bond market curve, with spreads put on top of that to give some credit ideas. Easy enough, right?
Our guesses on the probable Fed’s terminal rate for this cycle are close to 3.5%, with plenty of caveats around this. To be clear, this is a rate we see the Fed moving down to in the context of continuing economic growth. If there is a recession or shock of some sort, then rates would likely go lower than that, for a time. It is a steady state rate or ‘neutral rate’ if you like.
The ‘neutral rate’ is thought of as the equilibrium rate the economy requires to run at full employment with no inflationary or deflationary bias. Before Covid central banks thought it was very low, negative in fact, which is why they held rates near zero. US inflation was running at just below 2%, near target, and it seemed that the Fed couldn’t raise rates without derailing what was anyway a rather feeble economic upswing (at least until 2018). The ‘neutral rate’ then may have been only 1% or less. Or, expressed in real terms, about -1%.
In its latest Summary of Economic Projections, the Fed puts the neutral rate at 2.8%. This is an average of FOMC members’ projections, with a range from 2.4-3.8%. The average is lower than most private forecasters though the Fed has come up from 2.5% a year ago.
Why the neutral rate has likely risen
In my view, the neutral rate is likely higher than that, probably nearer 3.5%, for three reasons. First, after the experience of the 2010’s there is still a downward bias to rate expectations. But in the 2010’s the economy was recovering from the profound shock of the financial crisis which ruined balance sheets (banks, companies and households) and ushered in a long period of extreme caution. No wonder rates had to be low to get people to spend. Balance sheets are strong now and confidence has fully recovered.
Secondly, the 2010’s was a period of downward fiscal adjustment. Governments were trying to rein in spending and control deficits. That changed in the US under Trump, which is when interest rates began to rise again. But today the outlook is for continuing large fiscal deficits as governments grapple with ageing costs, pressure for more defence spending, subsidies for the climate transition and expensive industrial policies. This will tend to stimulate the economy, requiring higher interest rates to compensate.
Thirdly, productivity growth was very low in the 2010’s. But in the US it has been strong since Covid, apparently because the Covid shock displaced lots of workers who went back to work in more productive jobs. Europe and the UK missed out on this because workers were mostly put on furlough and went back to the same job. That effect may fade but I am optimistic that generative AI will lead to a new wave of faster productivity growth. If that is right, US GDP growth will be on a higher trend, perhaps 2.5% or so, rather than the assumed trend of 1.75%. Again, this will tend to raise the neutral rate of interest.
For the Federal Funds rate to move down to 3.5% obviously requires inflation to come down all the way to 2%. It is getting close but is not quite there yet. However, recent economic data suggests that the economy is slowing and, in particular, the labour market has eased considerably. This should allow the Fed to start cutting this month and make gradual further cuts towards 3.5%. That could be reached as early as next year if the economy is weak but, more likely, will take until 2026.
What would a 3.5% FFR mean for bonds?
In a fantasy equilibrium where both the Fed and investors thought that 3.5% was the right policy rate and it wouldn’t change any time soon we could expect 2-year Treasury yields to also be at about 3.5% while the 10-year yield would be a little higher, reflecting the ‘term premium’, the risk that inflation returns and rates need to go higher. In reality both 2-year and 10-year rates will swing around that 3.5% depending on expectations for the economy. Any sign of a recession and bond yields (2’s and 10’s) would dive under 3.5%, while concerns of returning inflation would see them rise well above it.
Currently, my expectation of a terminal rate of 3.5% is about where the market is. Rates futures point to 3.5% being reached in late 2025 and probably a bit below that in 2026. The 10-year yield of 3.8% reflects that too, allowing for a small positive term premium. But the 10-year yield can come down a little once policy rates actually fall and once inflation is confirmed to be coming down to 2% for sure.
Risks
Clearly there are upside risks to bond yields here, if inflation fails to come down as hoped or if the economy is stronger than expected. It is also possible that the neutral rate has moved up even higher than 3.5%. We used to put it at 4-5% in the 1990’s and early 2000’s. But there are also downside risks to the bond yield as well. Another recession will happen sometime for sure. And can we be certain that inflation will stop at 2%? Maybe it will go lower.
Conclusion for asset allocation
For investors, the fundamentals and the uncertainty around them, suggest to us that a neutral allocation makes sense for long-term bonds in a portfolio as long as the 10-year yield is in the 3-4% range. Above 4% an overweight is warranted while if we go below 3% again, depending on the circumstances, it may be time to consider going underweight once more.
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