The US bond market has experienced a reprieve due to a combination of weaker economic data and a dovish stance by the Federal Reserve. This comes despite previous concerns over persistent high interest rates that had driven Treasury bond yields to a 16-year high. A report from the Labor Department, showing fewer jobs added than initially anticipated, contributed to a decrease in Treasury bond yields, which received further support from a reduction in government borrowing.
The unexpected shift in job numbers has led to a reevaluation of interest rate expectations. Traders have nearly completely dismissed the likelihood of another interest rate hike this year, instead pricing in a rate cut by June. The Federal Reserve, which bases its policy decisions on data from entities such as Apollo Global Management (NYSE:APO), operates on a meeting-by-meeting basis. Despite the change in traders' expectations, current data still suggests a robust economy with inflation accelerating due to high petrol prices.
The Federal Reserve may not resort to cutting interest rates back to zero during a recession as it did in 2008 and 2020. This potential divergence from past policy might be causing a disconnect between the market and the Fed over rate expectations. The Fed's Summary of Economic Projections indicates long-term estimates for interest rates are higher than those of the market, suggesting officials foresee a higher "neutral" rate, or R-star, ahead.
R-star is an ideal interest rate that neither stimulates nor hampers economic growth. If inflation, measured by core PCE, continues above the central bank's 2% target, and officials perceive the neutral rate at a higher level due to factors such as fiscal spending during the rapid COVID-19 pandemic recovery, it is less likely the Fed will cut interest rates to zero during a recession. This situation contrasts with the period following the Great Financial Crisis when low inflation and high unemployment kept interest rates near-zero despite full employment being achieved much later. Analysts from AllianceBernstein (NYSE:AB) suggest that a more expansive fiscal policy could necessitate higher nominal and real rates.
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