MacroResearchBoard

Fed Reconsiders R-Star While Market Overstates Future Rate Cuts – November 6, 2023

A just-published report our investment strategy in the context of the surge in bond yields this year, and their more recent retreat.  Of the many arguments used to explain the surge in bond yields this year, in our view the most persuasive is that the market has embraced our long-held argument that the Fed’s 2.5% estimated long-run equilibrium policy rate is too low and that investors would eventually demand more compensation for greater future policy (monetary and fiscal) uncertainty and inflation risks in the form of a higher bond term premium.

In short, the market has bought into the “higher for longer” Fed policy rate, which we believe is consistent with a full normalization of monetary policy after the abnormal 2010-2021 period of household sector deleveraging and the pandemic. Several members of the Fed have already raised their estimates of the long-run equilibrium rate and we expect others to follow suit over time.

History suggests that U.S. Treasury (and G7 government bond) yields may eventually push higher as markets unwind the 75 bps of Fed rates cut discounted for 2024. Such a move would also be consistent with the 10-year Treasury yield peaking at a rate slightly above the Fed’s terminal rate, as it has done in the past.