Bond Traders Make Risky Bets on Neutral Rate ‘No One Knows’
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Bond Traders Make Risky Bets on Neutral Rate ‘No One Knows’
Liz Capo McCormick and Ye Xie
6 min read
(Bloomberg) -- On Wall Street’s bond desks, everyone, it seems, has an opinion on the neutral rate. It’s 3.3%. No, it’s 4.5%. Actually, it’s 2.4%. And on and on, all day long, five days a week.
The truth is, as the bond veteran Greg Peters puts it, “no one knows what neutral is.”
Of course, they know what it is. That’s fairly straightforward: the level of benchmark interest rates that neither boosts nor slows the US economy. They just can’t quite figure out, though, how to calculate it with any precision in an economy that’s still adjusting to all the shocks it got on both the supply and demand side during the pandemic.
Which is why those estimates on Wall Street — and inside the halls of the Federal Reserve itself — are all over the place. And it means, in turn, that investors have wildly different takes on whether the Fed’s three-month-old easing cycle — designed to bring the benchmark rate back down to neutral as inflation cools — is just beginning or getting close to the end.
All of this has made bond-yield swings violent of late, especially in the wake of data releases suggesting a surprisingly resilient or weak economy. “Absolutely schizophrenic,” says Peters, who helps manage more than $800 billion as co-CIO at PGIM Fixed Income. “It’s really, really volatile.” On days, for instance, when the monthly jobs report is released, the move, up or down, in two-year Treasury yields is now six times greater on average than it was prior to 2022.
In other words, the stakes are raised in the bond market. Get the neutral-rate call wrong and you can lose a lot of money, an unnerving prospect for a group still trying to recoup the losses they racked up during a brutal three-year selloff that ran through last fall.
A bet, for instance, on a sub-3% neutral rate is a bet the Fed will cut the benchmark rate a couple more percentage points, making bonds yielding just above 4% today a buy. But if it turns out the Fed is actually almost done with cuts, then those bond positions amassed around current yields are vulnerable to fresh losses.
Peters’ solution is to play it safe. He’s part of a group on Wall Street comfortable acknowledging he doesn’t know where neutral is beyond the broadest of ranges — “I don’t understand the obsession with a made-up number” — and so his plan is to sell Treasuries when 10-year yields drop to 3.5% and buy them when yields climb to 4.5%.
For years, the neutral rate was widely considered to be pretty low. There were disagreements about the exact level, of course, but a broad consensus formed during the long, sluggish expansion that followed the 2008 financial crisis that it hovered somewhere around 2.5%.
Covid scrambled that. The inflation surge that followed the pandemic was not, as Fed policymakers had insisted, transitory. Nor was the boost to the economy that came with it. So much fiscal and monetary stimulus had been pumped into the financial system that both inflation and growth remain high today — even after the Fed rapidly raised rates in 2022 and 2023.
Throw in other inflationary forces that are emerging — like the swollen US budget deficits and the gradual push to erect trade barriers across the globe — and it’s clear to most everyone (save a few notable exceptions) that the neutral rate has risen. It’s just the magnitude that’s so hotly debated, including at Fed meetings.
Policy makers’ estimates of the long-run interest rate — broadly seen as a proxy for the neutral rate — are as low as 2.375% and as high as 3.75%. That’s the widest range since the Fed began publishing the figures over a decade ago. Officials will update their estimates when they huddle next week for a policy meeting in which they’re widely expected to to cut the benchmark rate another quarter point to a range of 4.25% to 4.5%.
Outside the Fed, the range is even wider. Lorie Logan, the president of the Dallas Fed, has tabulated the estimates ginned up all across economic circles. She figures the lowest of them is around 2.7% and the highest about 4.6%, effectively equaling the current benchmark rate.
Given all this confusion, there are some investors who, like Peters, are simply avoiding bold calls. At TwentyFour Asset Management, portfolio manager Felipe Villarroel is trying to avoid taking short-term bond positions that could get hammered by a data release or two that go against him. And Thomas Kennedy, the chief investment strategist at JPMorgan Private Bank, is urging many of his clients to reduce risk in their portfolios.
“You don’t know where the Fed is going to go. So you have to be either beholden to their volatility,” Kennedy says, “or you need to respect that there’s a lot of outcomes and you should really not be taking excessive risk here.”
Conviction Camp
Then there’s the camp that has a strong belief in their neutral-rate call and wants the chance to parlay it into a big score for clients. “This is exactly what people wanted,” says Max Kettner, chief multi-asset strategist at HSBC Global Research. At least it is for those who a decade ago were lamenting how perennially uber-low rates had killed volatility — and money-making opportunities — in the bond market. “Back in 2016, 2017, if you were a macro guy you were like what do I do? Why am I here?”
For Henry McVey, a partner at KKR & Co., the formula for fixed-income portfolios right now is simple: sell long-term bonds and load up on cash along with assets that have a “dividend or cash-flow characteristic that’s much more attractive with a higher neutral rate,” like infrastructure or real estate. That’s because he’s convinced the neutral rate has jumped above 3%, a view he’s even more confident in after the election of Donald Trump, who, he says, will implement pro-business policies that further stoke growth.
At Deutsche Bank, the strategists go one further and peg the neutral rate right around 4% and, as a result, 10-year yields around 4.65% by year-end (up from roughly 4.3% now).
On the flip side, the money managers at TCW Group Inc. aren’t budging from their call that the pandemic didn’t change the neutral rate much, if at all. This has been a money-losing wager that’s pushed TCW’s flagship funds toward the bottom of industry rankings the past few years.
But they’re sticking with Treasuries in the two- to five-year range — part of a broader wager that the yield curve will steepen — because they expect the US economy to slow next year and the Fed to cut rates a lot more.
“We still think neutral is kind of the North Star at 2.5%,” said Bret Barker, co-head of global rates at TCW.
