The Strategist

Paradigm shift: getting used to higher neutral rates

Ahead of the expected interest rate cuts by central banks, investors are wondering where rates may ultimately stabilise and are looking at "neutral" policy rates. We believe current rates to be restrictive, but a return to the very low rates of the past decade and a half is unlikely. This should offer broad-based opportunities in a cross-asset portfolio.

Tina Jessop, Senior Economist, LGT Private Banking
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The Strategist: Neutral rates
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Despite the surprising resilience of the US economy and a later than expected start to the US rate cut cycle, we believe that central bank policy rates are in restrictive territory. The Swiss National Bank was the first major central bank to cut rates and the European Central Bank (ECB) is bound to follow suit in June. We also continue to expect that this year will bring a change in US monetary policy. With rate cuts on the horizon, investor focus is shifting to the pace of the coming adjustments and where interest rates may ultimately stabilise. At the heart of this lies the concept of the "neutral" policy rate, which neither stimulates nor restrains economic activity, allowing for full employment and stable inflation. 

Changing fundamentals

Since the 1990s, and particularly in the period following the global financial crisis, these neutral rates have been on a steady decline. Since 2008, post-financial crisis deleveraging and underinvestment in infrastructure have lowered neutral rates. At the same time, productivity growth has slowed, falling to below 1% in the case of the US. As a result, the period following the global financial crisis has been one of unusually low interest rates. Today's investment landscape looks dramatically different. Geopolitical tensions, climate concerns and leaps in artificial intelligence are now driving massive investment in national security, supply chain resilience, the energy transition and technology. At the same time, technological progress and artificial intelligence are expected to boost annual productivity growth in the coming years.

Return to pre-pandemic levels unlikely 

We believe the neutral level of interest is approximately 3.5% for the US Fed Funds rate (0.5-1% in real terms when adjusted for trend inflation rates) and at 1.5-2% in the euro area for the ECB deposit rate (around 0% in real terms). Barring an external shock or an unexpected credit event, central bank rates will not return to the exceptionally low levels of the post-GFC period. Over the course of 2024, we anticipate two to three rate cuts in the US Fed Funds rate and three to four cuts in the ECB deposit rate, with a data-dependent path for 2025. Normalisation to neutral rates will take time, especially in the US, with stronger growth and stickier inflation.

Rate cuts tend to be beneficial for risk assets, if they are accompanied by stable economic growth. We believe the current environment provides such a backdrop, but equity and credit markets have largely priced this in already. Upside from current levels must therefore come primarily from improving fundamentals, such as solid, broader-based earnings growth, rather than from lower interest rates. Government bond yields are displaying unusual swings as investors try to assess the appropriate level of monetary policy for the cycle and the long-term structural neutral level. 

Higher interest rates provide opportunities 

With interest rates set to remain higher in the medium term than they were a decade and a half ago, this is a significant departure from the zero interest rate policy (ZIRP) or even negative interest rate policy (NIRP) environment of the pre-pandemic decade. While the ZIRP period was exceptionally favourable for many risk assets, the higher interest rate scenario we have described offers more broad-based investment and diversification opportunities in a cross-asset class view.

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