The bond market is caught in a "guessing game": What exactly is the Federal Reserve's interest rate anchor?

Currently, on Wall Street's bond trading desk, a "guessing game" is unfolding. Traders are debating what the Federal Reserve's "neutral interest rate" actually is. The "neutral interest rate" refers to the benchmark interest rate that neither stimulates nor restrains the economy. Although the concept of the neutral interest rate is theoretically clear, its specific value has become elusive after the supply and demand shocks caused by the pandemic. Everyone seems to have an opinion on the neutral interest rate. Some believe it is 3.3%, some think it is 4.5%, while others insist it is 2.4%. But as Greg Peters, co-chief investment officer of PGIM Fixed Income, said, "No one knows exactly what the neutral interest rate is." At next week's policy meeting, the Federal Reserve is expected to further lower the benchmark interest rate. Ahead of the Federal Reserve's Rate Decision, a "Big Discussion" on the Neutral Interest Rate Range For years, the market has generally believed that the neutral interest rate is at a relatively low level, around 2.5%. This consensus gradually formed during the economic recovery period after the 2008 financial crisis. The COVID-19 pandemic disrupted the existing balance. The inflation triggered by the pandemic far exceeded the Federal Reserve's expectations. Massive fiscal and monetary stimulus injected into the economy has led to current inflation and economic growth remaining high, even though the Federal Reserve has significantly raised interest rates without effectively curbing it. In addition, the continuously expanding U.S. fiscal deficit and global trade barriers have also contributed to rising inflation. Most people have recognized that, under the influence of these factors, the level of the neutral interest rate has increased. However, there is significant disagreement within the Federal Reserve regarding the specific level of the neutral interest rate, with estimates ranging from 2.375% to 3.75%. At next week's policy meeting, the Federal Reserve is expected to further lower the benchmark interest rate. Dallas Federal Reserve President Lorie Logan has compiled a table summarizing various estimates of the neutral interest rate. She believes that these estimates vary widely, with a low of about 2.7% and a high of up to 4.6%, while the current benchmark interest rate is right at the high end of this range. The Fog of Neutral Interest Rate, Bond Market in Turmoil Due to the diversity of neutral interest rate estimates, investors have different views on the Federal Reserve's monetary policy outlook. This has also led to significant volatility in the bond market, especially after economic data releases. For example, when this month's non-farm payroll report was released, the volatility of the two-year U.S. Treasury yield was on average six times greater than before 2022. For investors, incorrect judgments about the neutral interest rate can lead to substantial economic losses. Peters stated: "It's absolutely schizophrenia; it's really very, very unstable." In the face of uncertainty, Peters has chosen a conservative strategy, selling when the 10-year Treasury yield falls to 3.5% and buying when it rises to 4.5% to cope with market fluctuations. Felipe Villarroel of TwentyFour Asset Management avoids overly short-term bond positions to mitigate the impact of data releases. Thomas Kennedy, chief investment strategist at JP Morgan Private Bank, advises clients to reduce risk. He stated: "The direction of the Federal Reserve is difficult to predict, and market volatility is high. Therefore, either prepare yourself psychologically to cope with the fluctuations, or do not invest too much money here." A Market Full of More Changes and Opportunities However, some investors are confident in their neutral interest rate predictions, hoping to achieve significant returns for their clients. Max Kettner, Chief Multi-Asset Strategist at HSBC Global Research, believes that this is exactly what those who felt the market was too calm due to the low interest rate environment have been waiting for: a market full of more changes and opportunities. Henry McVey of KKR & Co. insists that the neutral interest rate has exceeded 3%, and therefore recommends investing in assets with higher long-term returns. After Trump's election, he became more confident in this view, believing that Trump will implement pro-business policies that further stimulate growth. Deutsche Bank's strategists set the neutral interest rate at around 4% and expect the yield on 10-year Treasury bonds to reach 4.65% by the end of the year. In contrast, fund managers at TCW Group maintain that the pandemic has not significantly changed the neutral interest rate. They believe the U.S. economy will slow down next year and expect the Federal Reserve to further cut interest rates