Currently, a "guessing game" is unfolding at the bond trading desks on Wall Street. Traders are in heated debate over what the Federal Reserve's "neutral interest rate" actually is.

"Neutral interest rate" refers to the benchmark interest rate that neither stimulates nor hinders the economy. Although the concept of the neutral interest rate is theoretically clear, its specific value has become elusive after the supply and demand shocks triggered by the pandemic.

Everyone seems to have their own opinion on the neutral interest rate. Some believe it is 3.3%, others think it is 4.5%, and some insist it is 2.4%.

But as Greg Peters, Co-Head of Fixed Income at PGIM, said, "No one knows exactly what the neutral interest rate is." At next week's policy meeting, the Federal Reserve is expected to further lower the benchmark interest rate.

On the eve of the Federal Reserve's interest rate decision, there is a big discussion in the market about the neutral interest rate range.

For many years, the market has generally believed that the neutral interest rate is at a low level, around 2.5%. This consensus gradually formed during the economic recovery period after the 2008 financial crisis.

The COVID-19 pandemic disrupted the existing balance. The inflation triggered after the pandemic far exceeded the Federal Reserve's expectations. Large-scale fiscal and monetary stimulus policies injected into the economy have led to current high inflation and economic growth, even with significant interest rate hikes by the Federal Reserve proving ineffective.

In addition, the continually expanding USA fiscal deficit and global trade barriers are also driving inflation. Most people have recognized that the neutral interest rate level has increased under the influence of these factors.

However, there is significant disagreement within the Federal Reserve regarding the specific level of the neutral interest rate, which is believed to range from 2.375% to 3.75%. At the policy meeting next week, the Federal Reserve is expected to further lower the benchmark interest rate.

Dallas Fed President Lorie Logan summarized estimates of the neutral interest rate from various parties into a table. She believes that these estimates vary widely, with the lowest around 2.7% and the highest reaching up to 4.6%, while the current benchmark interest rate is exactly at the high end of this Range.

The fog surrounding the neutral interest rate has led to dramatic fluctuations in the Bonds market.

Due to the diversity of neutral interest rate estimates, investors have different views on the Federal Reserve's monetary policy outlook. This has also resulted in severe volatility in the Bonds market, especially following the release of economic data.

For example, when the non-farm payroll report was released this month, the fluctuation range of the two-year US Treasury yield was on average six times larger than before 2022.

For investors, an incorrect judgment on the neutral interest rate could lead to tremendous economic losses. Peters stated:

"It is absolutely schizophrenia; it really is very, very unstable."

In the face of uncertainty, Peters chose a conservative strategy, selling when the 10-year government bond yield fell to 3.5% and buying when it rose to 4.5%, to cope with market fluctuations.

Felipe Villarroel from TwentyFour Asset Management company avoids overly short-term bond positions to prevent being affected by data releases. Thomas Kennedy, chief investment strategist at JPMorgan Private Bank, suggests that clients reduce risk. He stated:

"The Fed's direction is difficult to predict, and market fluctuations are significant. Therefore, either be mentally prepared to cope with the volatility, or do not invest too much money here."

A market full of more changes and opportunities.

However, some investors are confident in their neutral rate predictions, hoping to achieve high returns for their clients.

Max Kettner, chief multi-asset strategist at HSBC Global Research, believes this is what people who felt the market was too calm due to the low interest rate environment have been waiting for: a market full of more changes and opportunities.

Henry McVey from KKR & Co. insists that the neutral rate has exceeded 3% and therefore recommends investing in assets with higher long-term returns. After Trump's election, he became more confident in this view and believes that Trump will implement further pro-business policies to stimulate growth.

Strategists at Deutsche Bank set the neutral rate at around 4% and expect the 10-year government bond yield to reach 4.65% by the end of the year. In contrast, fund managers at TCW Group insist that the pandemic has not significantly changed the neutral rate. They expect the US economy to slow down next year and anticipate further rate cuts by the Fed.

Editor/ping