Federal Reserve New York Fed President John Williams noted that low neutral interest rates (R-star) are still around due to long-term trends in demographics and productivity. During a speech in Mexico City, Williams stated that growth-adjusted R-star estimates are about 0.5% for the U.S., euro area, U.K., and Canada, aligning with pre-pandemic numbers. He explained that figuring out R-star is complicated, especially with factors like inflation caused by the pandemic and rising rates worldwide. Williams stressed that structural trends indicate rates will likely stay low. He advised policymakers to be cautious about relying too heavily on exact R-star estimates due to the uncertainties involved. He did not comment on the current situation regarding monetary policy.

The Low Neutral Rate of Interest

The idea that the neutral interest rate remains low, near 0.5%, implies that today’s high-rate environment is not permanent, but rather a temporary reaction to recent inflation shocks. This challenges the market’s view that we are entering a period of higher rates. For traders, this means that when rates eventually go down, the drop could be larger than anticipated. Recent data supports this view, showing a slowing economy. For example, the second-quarter GDP for 2025 was revised down to just 1.2% annualized growth. Although July’s core CPI report indicated that inflation is still stubborn at 2.8%, the slowing economy suggests that policies are already quite restrictive. As a result, we can expect the Federal Reserve to be less willing to keep rates at current levels for much longer. In the coming weeks, this outlook favors trades that anticipate a steeper yield curve, indicating that long-term rates will likely drop faster than short-term rates when easing begins. Reflecting on the deep inversions seen in 2023 and 2024, this would signal a return to a more standard monetary policy. Therefore, positioning in SOFR futures to benefit from potential rate cuts in mid-2026 seems increasingly appealing.

For Options Traders

For options traders, this viewpoint suggests that longer-dated call options on Treasury bond futures are currently underpriced. The market might not fully recognize the chance for a quick shift back to a low-rate environment once inflation is under control. Investing in upside exposure to bond prices—which rise as yields fall—could be a valuable opportunity. Create your live VT Markets account and start trading now.

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