Two years after inflation surged, the Federal Reserve has made limited progress tamping it down. A coterie of investors in the bond market is betting not only that policymakers will win, but that they’re right in anticipating the era of low long-term interest rates will return.
Gene Tannuzzo, global head of fixed income at Columbia Threadneedle Investments, is one of them.
“I’d argue the Fed is regaining their inflation credibility, slowly,” he said in a telephone interview. “As they get inflation closer to the target, their long-run rate will again serve as a credible anchor for yields.”
That thinking is visible in consensus projections, which see 10-year yields coming down over time to closer to 3% in 2024 and 2025, versus the current level of around 3.69%, Bloomberg surveys show. The consensus has got it wrong in the past, however — a little over a year ago, forecasters thought 10-year yields would now be below 3%.
As Tannuzzo sees it, there remains for the moment what he calls a “Fed credibility risk premium,” as seen in the gap between 10-year Treasury yields and the central bankers’ estimate of the long-run policy rate.
Before the pandemic, investors saw the Fed’s estimate as a likely outcome, something that helped to hold Treasury yields down. Now, however, a number of economists, including Harvard University’s Kenneth Rogoff, say rates will settle at a higher level over the longer haul — thanks to factors including costlier supply chains and stepped-up defense spending.
Tannuzzo and like-minded investors are siding instead with policymakers such as New York Fed President John Williams, who recently laid out the case for a return to low rates. These money managers also see the Fed needing to usher in a recession to ultimately win the battle with inflation, an outcome that will boost the allure of government debt.
For now, the Fed’s preferred inflation gauge is running at more than double its 2% target. The 4.4% annual pace of gains for April would, if sustained, leave investors in sub-4% 10-year notes worse off over time. The bulls are counting on things to change.
“Over the next couple of years we think long-term rates should be lower,” said Donald Ellenberger, a senior portfolio manager at Federated Hermes. “If the Fed is serious about getting inflation down to 2% it’s going to take a recession to do it. And recessions usually result in a flight-to-quality buying of Treasuries.”
Buying Opportunity
Ellenberger, who leads a team that manages Federated Hermes’s over-$12 billion Total Return fund, added, “We think it’s not a bad time to add duration now,” with any further climb in Treasury yields offering an opportunity to stock up.
What Bloomberg strategists say...
“The Federal Reserve may be reluctant to cut interest rates this year if inflationary concerns persist and the labor market stays resilient enough to limit concerns about a prolonged recession. Our view aligns with Bloomberg Economics, which believes the Fed won’t cut rates this year.” —Ira Jersey, chief US interest-rate strategist at Bloomberg Intelligence
Not all are convinced yields are heading lower. Jim Grant, founder of Grant’s Interest Rate Observer, says he sees a “long cycle of rising rates” ahead.
Fed policymakers, who are set to update their estimate for the policy rate over the long run next week, last calculated it at 2.5% — much the same as they did before the pandemic.
The Fed has kept its long-run rate projection steady despite the fact that the economy has gone through enormous change amid the pandemic and Russia’s invasion of Ukraine. Labor market participation rates remain below pre-Covid levels, supply chains are shifting to emphasize resilience over pure efficiency, and government debt loads are now much bigger.
Some question where the long-run neutral interest rate, known by researchers as “R-star,” is likely to settle. The gauge is essentially an expression of what rate of interest is needed to gather savings and allow the economy to grow at its potential.
“My over-arching view for R-star is that all of these estimates are really uncertain,” said Matthew Luzzetti, chief economist at Deutsche Bank AG.
Potential growth rates are hard to estimate in real time and can be influenced by many different factors: for example, estimating how the dawn of labor-saving smarter automation with artificial intelligence can balance out the limited growth of US labor supply going forward.
The bottom line for Kathy Jones, chief fixed-income strategist at Charles Schwab, whose asset-management unit oversees more than $755 billion, is that “a major central bank with its own currency can get the inflation rate it wants if it’s willing to persist.”
“We’ve been in the camp suggesting people add duration as yields moved up,” she said. “I don’t think the world has changed significantly.”
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