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Weaker economic data and a more dovish stance from the Federal Reserve this week helped bolster the battered U.S. bond market. However, some analysts warn that actual relief may be limited as higher interest rates are here to stay.
Fears that the Fed would keep interest rates “high for longer” in October pushed Treasury yields to their highest in 16 years. Treasury yields are sensitive to interest rate expectations, and traders bet that the strength of the U.S. economy – even amid the highest interest rates in a generation – would force the Fed to keep monetary policy tight.
Those fears began to dissipate on Friday after the Labor Department reported that U.S. employers added 150,000 jobs last month – fewer than Bloomberg economists had forecast and about half as many as in September. Aided by the Fed’s dovish stance on Wednesday and the announcement of a slower increase in government debt, Treasury yields fell to their lowest level in over a month.
The falling yields were accompanied by a shift in interest rate expectations. Moves in the futures market Friday morning suggested that traders had all but ruled out the possibility of another rate hike this year, while at the same time fully pricing in a rate cut as early as June. Before the new job numbers were published, a cut was forecast in July.
But the Fed has explicitly said it will approach any policy decision on a meeting-by-meeting basis and base its deliberations on data. And a lot of that data still shows the economy continuing to be hot. Thanks to higher gasoline prices, inflation has accelerated in recent months and the US economy grew by a whopping 4.9 percent in the third quarter.
Additionally, while the Fed will likely cut interest rates in the event of a recession, it may not cut rates back to zero, as it did in 2008 and 2020. Analysts believe that differing views on a return to zero interest rates could contribute to a greater disconnect between the market and the Fed’s inflated interest rate expectations.
“Another way to say higher for longer is ‘not zero,’” said Torsten Sløk, chief economist at Apollo Global Management. “We are not going back to zero.”
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At its September meeting, the Fed released its latest summary of economic forecasts – its so-called dot plot, which reflects members’ forecasts of how interest rates, inflation and growth will develop in the coming years. Official interest rate expectations were higher than in the previous survey in June.
Crucially, the Fed’s estimates for longer-term interest rates are higher than the market’s – and higher than its own previous estimates – suggesting that officials expect a higher “neutral” rate.
This neutral interest rate – also called the R-Star – is the Fed’s “Goldilocks” interest rate: the interest rate that neither stimulates nor hinders economic growth in the absence of inflationary or deflationary pressures. When the neutral interest rate matches actual market interest rates, the economy typically reaches its full potential.
In practice, the neutral interest rate is an unclear number that is difficult to determine. But the Fed’s changing expectations for long-term interest rates suggest officials expect the neutral rate to rise. And if inflation continues above the central bank’s 2 percent target and officials see the neutral interest rate at higher levels, the Fed may be less likely to cut rates to zero in the event of a recession.
At their September meeting, the Fed’s “central tendency” survey – which excludes the first and last three responses – showed officials seeing long-term interest rates in a range of 2.5 percent to 3.3 percent, which was significantly higher than the June forecast of 2.5-2.8 percent.
This is all dramatically different from the period between 2008 and 2019, when the US economy was recovering from the Great Financial Crisis. Interest rates had been cut to near zero, but inflation remained low, with core PCE (personal consumption expenditures) – the Fed’s preferred inflation indicator – below its 2 percent target. And unemployment was high.
“If you really think about why the rates were so low from 2008 to 2018, it’s because the unemployment rate was very, very high for many, many years,” says Sløk. “It took a long time for the Fed to get back to full employment after the 2008 financial crisis.”
But the state of the US economy is completely different today: the country has recovered from the Covid-19 pandemic much faster than anyone expected; government spending is higher; Inflation was above target despite interest rates being at their highest in a generation. and unemployment has remained low.
“There are good reasons to believe that we are no longer in a world of zero interest rates,” argues Eric Winograd, head of developed markets economist research at AllianceBernstein. “Sustained expansionary fiscal policy is likely to support higher interest rates, all other parameters remaining the same – both nominal and real. For me, the new normal probably means higher interest rates once the dust settles from this cycle.”
Source : www.ft.com