Bond bulls may have just had a fresh speed bump placed in front of them by Federal Reserve Bank of San Francisco President Mary Daly.
Daly said the neutral interest rate — also known as R-star — may be higher now than it was before the pandemic, adding to the groundswell of concern the central bank's benchmark will stay higher for longer. Her comments also seem at odds with traders betting the Fed will cut rates as many as three times next year.
"The last mile of solving inflation was always going to be the toughest with the sticky services and rent inflation," said James Wilson, a senior portfolio manager at Jamieson Coote Bonds Pty in Melbourne. "It is very plausible to see cash rates stay higher for longer in the face of higher neutral rates."
Daly's comments, made Tuesday in Chicago, help focus attention once more on a topic that has captivated trading desks in recent months, the so-called R-star gauge as it is commonly referred to in economic models. That's the theoretical level at which rates neither stimulate nor restrict an economy.
Fed officials have estimated the neutral rate at 2.5% before the pandemic. Daly said yesterday she could imagine it at anywhere between 2.5% and 3%.
If the Fed wants to contain rampant inflation – as it does now – it raises its benchmark above that neutral setting. While economists define R-star in inflation-adjusted terms, it's sometimes also a short-hand reference to the central bank's nominal policy setting.
Treasuries have bounced back from a five-month selloff this week as Fed speakers — including Daly —- signaled the recent spike in bond yields may mean the they won't have to take rates any higher. U.S. sovereign bonds are still heading for a record third year of losses on concern stubborn price pressures will convince the central bank to keep borrowing costs elevated well beyond the six-month plateau typically seen in previous tightening cycles.
"The questions surrounding R* have been posed for a while now," said Calvin Yeoh, who helps manage the Merlion Fund at Blue Edge Advisors, adding "Daly's comments are catching up to the market, not the other way around."
"The simple arithmetic of positive growth, above-target inflation and a tight labor market while one-year real rates are above 1.5% tells you that a nominal 2.5% long-term rate is ambitiously low unless we get a recession," he said.
