August, 2024
The sell-off in global stocks over the past month has been a correction from sky-high share valuations of a few AI firms. It may also be a reckoning for a decade and a half of cheap money and massive deficit spending by the U.S. government. Wall Street and Washington politicos habitually criticize the Federal Reserve for not cutting interest rates enough to alleviate occasional business or market problems, as if Fed actions are a magic cure for whatever ails an economy.
Fed watching and associated speculation is encouraged by financial media since writers need airtime and column space to fill. But, contrary to whatever you may believe, even knowing what actions that the Fed will take may not provide you with an investment advantage. That’s because the Fed’s expected actions from the release of meeting minutes or chairman pronouncements are very quickly reflected in market prices. Even before rate changes are publicly announced, markets have formed their collective expectation of what the Fed’s new rate will be, and so may not need further adjustment.
The Fed has much less influence over the entire bond market than investors believe. There are over 100 different interest rate indexes. Interest rates reflected in those indexes are set by daily market trading. They vary widely due to matters often having little to do with the Fed prevailing funds rate. For example, the Fed’s target range has remained constant over the past year. Yet during that period, the 10-year Treasury yield has widely fluctuated, falling in the last quarter of 2023 before rising again this year and then falling once again.
Exhibit 1: Comparing 10-Year Treasury Yields, Fed Funds Rate
July 27, 2023–June 30, 2024
Source: Dimensional Fund Advisors, Wes Crill. Fed funds rate data from FRED. Ten-year constant maturity Treasury index yields from FactSet. Past performance is not a guarantee of future results.
Your bond portfolio’s monthly return is not likely correlated with that month’s prevailing Fed funds rate. Exhibit 1 illustrates why drawing actionable conclusions from Fed watching is so hard. The market’s interest rates anticipate a Fed action, so when a Fed rate change announcement occurs, it doesn’t move in lockstep. That’s because market participants are constantly processing information by trading activities that might factor into the Fed’s ultimate rate-setting decision. And unless tomorrow’s Treasury yields are discoverable with your time machine, it’s unlikely your interest rate predictions will consistently outperform those of the market collectively.
Forward-looking adjustments become more apparent when looking at Treasury yields movements in months when the Fed has raised or cut its rate, as in Exhibit 2. Treasury yields actually increased in about one-third of those months when the Fed reduced rates, and moved in the opposite direction at a similar frequency in those months when the Fed raised rates.
This implies that even if you had perfect predictive capability of what Fed actions would be, it would not be sufficient to tell you how Treasuries traded in the markets will perform about a third of the time! That’s sufficient reason for most investors to ignore Fed rate predictions when planning and managing bond market portfolios.
Exhibit 2: Changes in 10-Year US Treasury Yields vs. Fed Fund Rates
January 31, 1983–June 30, 2024
Source: Dimensional Fund Advisors, Wes Crill. Federal Reserve Economic Data (FRED) from the Federal Reserve Bank of St. Louis. Data series used: Market Yield on U.S. Treasury Securities at 10-Year Constant Maturity, Quoted on an Investment Basis, Percent, Daily, Not Seasonally Adjusted (DGS10), Federal Funds Target Rate (DISCONTINUED), Percent, Daily, Not Seasonally Adjusted (DFEDTAR), and Federal Funds Target Range – Upper Limit, Percent, Daily, Not Seasonally Adjusted (DFEDTARU). Circles corresponding to a rate cut do not sum to 100% due to monthly periods of no yield change for the 10-Year US Treasury bond. Past performance is not a guarantee of future results.
Congress is gridlocked on economic policy, but clamors in unity for the Fed to reduce rates. That reflects the importance of cheap money for government spending and bad tax ideas to win the favor of voters. But rising debt at higher interest rates restrains Congressional spending. Money is never free and making it cheap for increased spending has led to unsustainable distortions. The shock of a major stock selloff and increased volatility is like an car engine’s red oil light flashing. Depending on high portfolio returns of the past to continue indefinitely is a highly risky planning strategy.