AXA IM: Based on r-star markets need to be careful pricing in too many ratecuts

July 5, 2024

In his 'The view from the Core CIO Office' Alessandro Tenori, CIO Europe at AXA Investment Managers, writes that based on the current natural interest rate (aka r-star), markets need to be careful in pricing in too many rate cuts. "Looking ahead, it is likely the current level of the Fed Funds Rate is above most estimates of the r-star and we feel that markets need to be careful about pricing in too many rate cuts. This in turn has implications for expected returns across bond markets and is a strong support for short-duration strategies in fixed income, especially in an environment of inverted yield curves" Tenori writes.

'Looking ahead, it is likely the current level of the Fed Funds Rate is above most estimates of the r-star and we feel that markets need to be careful about pricing in too many rate cuts. This in turn has implications for expected returns across bond markets and is a strong support for short-duration strategies in fixed income, especially in an environment of inverted yield curves',  Tenori writes.

He explains: 'The r-star is the neutral rate of interest, net of inflation, that supports the economy at full employment or maximum output, while keeping inflation constant. Together with monetary policy anticipation, expected inflation and the term premium, r-star defines the level of risk-free bond yields. In addition to model estimates, we can extract useful information from the yield curve. Currently, a market-based measure of r-star stands approximately 150-200bp above pre-COVID-19 levels.

The high level of uncertainty around r-star automatically translates into uncertainty about the monetary policy stance. What if the natural interest rate was higher than current estimates? What if the long-run dot (r-star) at 2.6% failed to capture the changing structure of the economy? Evidently, the actual monetary policy stance would not be as tight as is widely believed, in which case risk premia across asset classes are probably too compressed to compensate investors for a scenario of repricing of a new interest rate regime.

Furthermore, this high level of uncertainty comes on top of an economic policy mix, which somewhat dilutes central banks’ effort to control inflation. Expansionary fiscal policy, excess liquidity, the inverted yield curve, and risky assets’ valuations (financial conditions more broadly) could imply that the overall policy stance is not as “tight” as generally believed. In this case, implications for GDP growth, inflation and central banks’ reaction are obvious.'