Bond Traders Are Obsessing Over This Gauge Before Jackson Hole
An abstract interest-rate metric is dominating discussions across trading desks ahead of the Jackson Hole symposium, with investors wondering if Federal Reserve Chair Jerome Powell will weigh in, and bracing for further declines in US Treasuries if he does.
Fidelity International, Jupiter Asset Management and hedge fund Blue Edge Advisors are among those pondering the implications of whether there has been an increase in the neutral rate, also known as R*.
That’s the theoretical level at which rates neither stimulate nor restrict an economy. If the Fed wants to contain a price surge – as it does now – it raises its benchmark above that level. While economists define R* in inflation-adjusted terms, it’s sometimes also a short-hand reference to the central bank’s nominal policy setting.
So any hint at an upward revision would likely ripple across global markets, forcing a reevaluation on where fair value for Treasury yields is likely to land. An added complication: The level of rates that are best for an economy may not be the best for markets, risking disruptions in the financial system.
“For most traders, R* is like the appendix – assumed to be irrelevant to daily life until it suddenly bursts and makes you painfully care about it,” said Calvin Yeoh, who helps manage the Merlion Fund at Blue Edge.
Fed policymakers have since 2019 had a 2.5% median estimate for the policy rate over the long run — essentially their gauge of neutral — down from 3.5% eight years ago. Boosting it could intensify discussions about whether trend inflation rates are now higher, and whether investors ought to demand bigger premiums to buy longer-term Treasuries, according to Yeoh.
Those questions are already part of the zeitgeist of a market that sent 10-year Treasury yields to the highest since 2007 this week. The global borrowing benchmark was steady at around 4.24% in Asia trading Friday.
Despite the market chatter, many Fed watchers reckon Powell will dodge the topic when he speaks Friday. He told lawmakers in March, “Honestly, we don’t know” where neutral is. In his first Jackson Hole speech as Fed chair, in 2018, he emphasized the inherent uncertainty around estimates of such long-run variables.
For his part, New York Fed President John Williams said in May that the pandemic hadn’t done much to R*. Others aren’t so sure. Reasons for raising the neutral rate include the economy’s recent resilience, a rising budget deficit, a potential rundown in savings, spending more on the shift from carbon, and the chance technological gains such as artificial intelligence will boost productivity.
“If the Fed moves toward the idea that R* could be higher than current estimates of 2.5%, the main implication of that would be that policy is not as restrictive as we might’ve previously assumed,” said Sally Auld, chief investment officer at JBWere Ltd. “Therefore, the market’s expectations that the Fed will deliver 100 basis points of rate cuts by the end of next year are wrong.”
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“One needn’t have a doctorate in econometrics or a model filled with pages of differential equations to identify a framework suggesting that the trend level of interest rates has pushed higher,” Cameron Crise, macro strategist.
Jay Barry, head of US government-bond strategy at JPMorgan Chase & Co., said that traders who pushed up yields this month due to expectations that Powell will suggest a higher neutral rate are at risk of disappointment.
“We think it’s somewhat unlikely the chair’s comments will foreshadow a larger change to the longer-run dot at the September FOMC meeting, as Chair Powell has repeatedly discussed policy as being restrictive,” Barry wrote in a note.
And using the history of past changes as a guide, “it would be difficult to conclude with certainty the chair would make an aggressive statement on this topic on Friday, even though the risk may lean in this direction.”
For Jupiter Asset Management’s Harry Richards, keeping close tabs on tangible factors such as inflation data matters far more for investors weighing the outlook on US debt.
“It’s something we think about an awful lot. Often you find out where that is when things start to go wrong,” Richards said of the neutral rate. But “what’s important to us more than the slightly ethereal measure of R* is to try and understand what’s going to be the key drivers in GDP and inflation.”
Another potential concrete indicator is orders for Treasury inflation-protected securities. An auction for 30-year TIPS on Thursday demonstrated middling demand. The debt was sold at a rate above where the when-issued security was trading just before bidding completed, a sign of lackluster appetite, though there were more bids compared with the amount of debt issued this time than at the prior auction in February.
By one measure, the market is already betting the Fed is behind the curve on neutral rates. A New York Fed measure of inflation-adjusted R* is hovering around 0.6%, while a swaps-based proxy — where 5-year inflation-adjusted yields will be in 5 years time — has jumped above 1%.
And prospects of a potentially higher neutral rate are not denting the appeal of Treasuries for some.
Some of the world’s biggest asset managers are favoring US bonds even as fears of higher-for-longer borrowing costs wiped out gains for Treasury bulls this year. Fidelity International, among those snapping up fixed-income securities, said Treasuries remain attractive even with any revisions to the neutral rate.
“Even if it moves, Treasuries at 4.5%, 4.4% give you enough cushion with some term premia over a revised R*,” money manager George Efstathopoulos said of 30-year yields.
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