Bond market overestimates when the Fed will stop raising rates, says Pimco
Pimco bets that the Fed will not raise rates more than three times between now and the end of 2019
The world’s biggest bond fund manager is dismissing the prospect of the Federal Reserve hiking interest rates more than three times before it terminates its tightening cycle.
That means Treasury yields are unlikely to take off anytime soon, said Anthony Crescenzi, market strategist at Pacific Investment Management, or Pimco.
He says the recent pronouncements of an unfolding bear market in bonds was premature, and reiterated his firm’s “new neutral” thesis that long-term economic factors including an aging population, weak productivity would cap the so-called neutral interest rate, the level at which monetary policy neither stimulates nor retards growth.
“For Treasury yields to move meaningfully from current levels, investors would have to expect either a higher or lower terminal rate for federal funds,” said Crescenzi, in a blog post published on Pimco’s website last Friday.
His remarks come as investors worry that the economy’s strong momentum will push the Federal Reserve to raise rates more times than expected. Growing Fed expectations have, in turn, raised bond yields for U.S. government paper, a development that became too much to bear for a stock market that has overlooked the impact of rising rates for much of the year.
Treasury yields have retreated since touching multiyear highs last week. Last Tuesday, the 10-year Treasury note yield TMUBMUSD10Y, +0.48% touched a multiyear high of 3.26% last Tuesday, while the long bond hit a four-year high of 3.40%. The 10-year yield now trades at 3.159%. Bond prices move in the opposite direction of yields.
But for Crescenzi, the recent stock market selloff underscored that “any tilt away from the extraordinary low-rate era can prompt quakes now and then.”
So far, bond traders have seen the current tightening cycle yielding one additional rate hike this year and two next year, based on the market for eurodollar futures, a derivatives product which allows for investors to bet on the direction of the U.S. central bank’s overnight lending rate. The current fed funds rate is between 2.00% and 2.25%.
But now market participants are now at a crux, with some asking themselves if their estimates of the Fed’s terminal rate was too shallow.
The case for repricing a more aggressive central bank strengthened after Fed Chairman Jerome Powell said the Fed was far away from reaching the neutral rate. Though some cautioned overreading his remarks in what could also be understood as a re-assertion of current monetary policy, bond traders had interpreted Powell’s remarks as part of a broader shift in the Federal Open Market Committee, its rate-setting body, towards a more hawkish stance.
“This decision point is why somewhat higher rates are plausible. Investors may have confidence in the Federal Reserve’s projection that its policy rate will peak at 3.4%, leading the Fed to push Treasury yields up to that level or a bit higher,” said Crescenzi, referring to the upper range of long-term expectations for the fed funds rate.
After all, the neutral rate is more of an “anchor and not a floor or a ceiling,” giving some room for interest rates to deviate from such estimates.
Still, Pimco forecasts the central bank the central bank to raise rates to no more than 2.75%-3.00% by the end of 2019.
Crescenzi said the aging baby boomer generation, demanding the support of a stretched labor force, could hamstring the economy’s long-term prospects. At the same time, weakness in business investment and infrastructure spending would ensure that tepid productivity growth will stay a fixture of the investing backdrop
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