First, the good news. With 2024’s midway point in sight, Treasuries are on the cusp of erasing their losses for the year as signs finally emerge that inflation and the labor market are both truly cooling. Traders are now betting that may be enough for the Federal Reserve to start cutting interest rates as soon as September.

But potentially limiting the central bank’s ability to cut and thus setting up a headwind for bonds is the growing view in markets that the economy’s so-called neutral rate — a theoretical level of borrowing costs that neither stimulates nor slows growth — is much higher than policymakers are currently projecting. 

“The significance is that when the economy inevitably decelerates, there will be fewer rate cuts and interest rates over the next ten years or so could be higher than they were over the last ten years,” said Troy Ludtka, senior US economist at SMBC Nikko Securities America, Inc.

Forward contracts referencing the five-year interest rate in the next five years — a proxy for the market’s view of where US rates might end up — have stalled at 3.6%. While that’s down from last year’s peak of 4.5%, it’s still more than one full percentage higher than the average over the past decade and above the Fed’s own estimate of 2.75%. 

This matters because it means the market is pricing in a much more elevated floor for yields. The practical implication is that there are potential limits to how far bonds can run. This should be a concern for investors gearing up for the kind of epic bond rally that rescued them late last year.

For now, the mood among investors is growing more and more upbeat. A Bloomberg gauge of Treasury returns was down just 0.3% in 2024 as of Friday after having lost as much as 3.4% for the year at its low point. Benchmark yields are down about half a percentage point from their year-to-date peak in April.

Traders in recent sessions have been loading up on contrarian bets that stand to benefit from greater odds the Fed will cut interest rates as soon as July, and demand for futures contracts that a rally in the bond market is booming. 

But if the market is right that the neutral rate – which cannot be observed in real time because it’s subject to too many forces – has permanently climbed, then the Fed’s current benchmark rate of more than 5% may be not as restrictive as perceived. Indeed, a Bloomberg gauge suggests financial conditions are relatively easy.

“We’ve only seen fairly gradual slowing of the economic growth, and that would suggest the neutral rate is meaningfully higher,” said Bob Elliott, CEO and chief investment officer at Unlimited Funds Inc. With the current economic conditions and limited risk premiums priced into long-maturity bonds, “cash looks more compelling than bonds do,” he added.

The true level of the neutral rate, or R-Star as it is also known, has become the subject of hot debate. Reasons for a possible upward shift, which would mark a reversal from a decades-long downward drift, include expectations for large and protracted government budget deficits and increased investment for battling climate change. 

Further gains in bonds may require a more pronounced slowdown in inflation and growth to prompt interest rate cuts more quickly and deeply than the Fed currently envisions. A higher neutral rate would make this scenario less likely. 

Economists expect data next week will show that the Fed’s preferred gauge of underlying inflation slowed to an annualized rate 2.6% last month from 2.8%. While that’s the lowest reading since March 2021, it remains above the Fed’s goal for 2% inflation. And the unemployment rate has been at or below 4% for more than two years, the best performance since 1960s. 

“While we do see pockets of both households and business suffering from higher rates, overall as a system, we clearly have handled it very well,” said Phoebe White, head of US inflation strategy at JPMorgan Chase & Co. 

The performance of financial markets also suggests the Fed’s policy may not be restrictive enough. The S&P 500 has hit records almost on a daily basis, even as shorter maturity inflation-adjusted rates, cited by Fed Chair Jerome Powell as an input for gauging the impact of Fed policy, have surged nearly 6 percentage points since 2022.

“You do have a market that’s been incredibly resilient in the face of higher real yields,” said Jerome Schneider, head of short-term portfolio management and funding at Pacific Investment Management Co.

With exception of a few Fed officials such as Governor Christopher Waller, most policymakers are moving to the camp of higher neutral rates. But their estimates varied in a wide range between 2.4% to 3.75%, underscoring the uncertainties in making the forecasts. 

Powell in his discussions with reporters on June 12, following the wrap of the central banks two-day policy meeting, seemed to downplay its importance in the Fed’s decision making, saying “we can’t really know” whether neutral rates have increased or not.

For some in the market, it’s not an unknown. It’s a new higher reality. And it’s a potential roadblock for a rally.