The US Treasury bond market has been rocked by the Federal Reserve's recent reassessment of interest rates, with long-term Treasury yields potentially headed higher. The economy's resilience in the face of aggressive interest rate tightening has raised questions about the current "neutral rate" for growth, which Fed officials have maintained is around 2.5%. However, models from the Fed suggest that the neutral rate may have increased, potentially leading to higher yields across the curve.
The US central bank has raised its benchmark federal funds rate from near zero to above 4.5% in the last 11 months and is poised to take it as high as 5.4% by mid-2023. The rise in interest rates has been fueled by better-than-expected employment, inflation, and retail sales data. The neutral rate, also known as "r-star," has implications for the Treasury market and investors.
If the neutral rate is revised upward, it would have adverse effects on the Treasury market and raise yields across the curve. The Fed is expected to publish fresh projections at its next policy meeting in March, but policymakers may be reluctant to upgrade their official estimates so soon. The relationship between policy tightening and the economy is uncertain, with the impact of the pandemic and the lag time between policy tightening also affecting the situation.
The concept of the neutral rate is theoretical, and the actual impact of interest rate hikes on the economy is uncertain. Homeowners and companies have locked in low borrowing costs before rates started rising, reducing interest rate sensitivity. Forecasters predict a recession in the near future, which would only prolong the uncertainty surrounding the true neutral rate.
