Markets are expecting the neutral rate — a theoretical rate that remains stable due to full employment and stable inflation — to stay higher than policymakers are forecasting. What does this mean for bond exchange-traded funds?

A higher neutral rate may limit the Federal Reserve's ability to cut interest rates, possibly causing headwinds for bonds, Bloomberg reports.

Forward contracts on the five-year interest rate in the next five years — a proxy for the market's view of where U.S. rates might land — have stagnated at 3.6%. That is down from last year's peak of 4.5%, but it's still more than one full percentage point higher than the average over the past decade and above the Fed's own estimate of 2.75%.

This indicates the market is pricing in a much more elevated floor for yields, according to Bloomberg. This may limit bond performance, which might hamper investors' hopes for the kind of bond rally that saved them late last year.

Also read: US Economy 'In State Of Unstable Equilibrium,' Study Finds

Investor sentiment is rising steadily, but a Bloomberg gauge of Treasury returns was down just 0.3% in 2024 as of Friday, after shedding 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, Bloomberg reported.

The true level of the neutral rate, also known as R-Star, may take an upward trend that would reverse a decades-long downward drift on expectations for large and protracted government budget deficits and increased spending on 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, according to Bloomberg.

Economists expect data next week to show that the Fed's preferred gauge of underlying inflation slowed to an annualized rate 2.6% last month from 2.8%.

That is the lowest reading since March 2021, but it still exceeds 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 the 1960s.

Price action: iShares Core U.S. Aggregate Bond ETF (NYSE:AGG) was up 0.01%, the Vanguard Total Bond Market Index Fund (NASDAQ:BND) was down 0.04% and the Vanguard Total International Bond Index Fund (NASDAQ:BNDX) slipped 0.12% at the time of publication Monday.

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