BenEisen

NEW YORK (MarketWatch) — The rally in U.S. Treasurys that pushed 10-year yields to their lowest level in nearly seven months reflects the likelihood that the Federal Reserve will keep rates low in a slowly growing global economy, according to Bill Gross, chief investment officer at Pimco.

The 10-year note US:10_YEAR  yield, which falls as bond prices rise, dropped more than 15 basis points to 2.50% in the past three sessions. That move is emblematic of the way interest rates should behave as the world shifts toward the “new neutral” paradigm outlined by Pimco earlier this week, the bond market veteran told MarketWatch in emailed comments.

Pimco

Bill Gross.

“2.50% currently reflects a 0.5% new neutral rate and seems fair for now,” Gross said.

The new-neutral outlook published by Gross and Pimco adviser Richard Clarida suggests that the global economy is transforming from a period of recovery after the financial crisis — termed the “new normal” back in 2009 — toward stability that is characterized by modest economic growth over the next three-to-five years.

With economies expanding more slowly than they did prior to the financial crisis, central banks are likely to keep their key interest rates low, cushioning lending rates from a sharp rise. In the U.S. the fed funds rate is currently anchored near zero, with many traders expecting it to begin rising in the middle of next year. But Gross suggested yields will be dictated by how high the Fed eventually hikes rates. It may stop at a lower point than it did in past rate cycles.

“If the new neutral policy rate is 0% and the Fed achieves its 2% inflation target, then the 10-year Treasury should trade at close to 2%. However, because of the large uncertainty as to what the New Neutral rate should be, I would not expect it to trade there,” the Pimco founder said.

Under his outlook, the Fed’s nominal funds rate would top out somewhere near 2% in the coming years. That’s a relatively small climb from the current rate of near zero.

Gross, whose flagship $230 billion Pimco Total Return Fund PTTRX, -0.19%  is the largest bond fund in the world, is among a growing group of investors and economists to suggest that the drop in bond yields since the beginning of the year reflects expectations of a lower Fed lending rate .

“Your perception of what yield level of the 10-year Treasury note represents value is a lot different if you think the fed funds rate is eventually going to peak at 2% than if you think the fed funds rate is eventually going to peak at 4%,” said Steve East, economist and strategist at Height Analytics, in a note to clients.

For its part, the Federal Reserve has said it could keep rates lower than is considered normal in the coming years. In the Fed’s March statement. the policy committee wrote: “Even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.”

However, the longer-run expectations of central bank officials suggest the fed funds rate could drift higher toward 4%, intensifying discussions about where the rate’s resting place will be.

The consensus forecast for average 10-year Treasury yields in 2015 is 3.6%, according to Blue Chip Economic Indicators.

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