May, 2023
The Federal Reserve Bank once again raised its rate another quarter point. It signaled that that may be the last increase for a while. A series of rate increases are the Fed’s effort to lower current high inflation while keeping employment full. Impact on the US dollar, a global reserve currency, is not their concern even though it has declined this year.
For several years, the Federal Reserve has actively responded to prevailing economic conditions. Consequently, fixed income investors have become increasingly focused on what the Fed may do. While predicting any Fed’s action is uncertain, data show that markets quickly incorporate any news related to Fed decisions into fixed income prices. Patterns in the pricing of Fed Funds futures contracts support this notion. Federal Fund futures contracts are financial instruments that capture market participants’ aggregate expectations of the future path of Fed funds rate changes.
Exhibit 1 below shows that many months prior to the Federal Reserve’s meeting last March, market participants used futures contracts to hedge against future potential adverse outcomes. During the twelve months leading up to the Fed’s announcement, for instance, CME Group used March 2023 future prices to assign probabilities to given Fed Fund rate changes. This exhibit uses probabilities of rate ranges to calculate a market-implied Fed Funds rate for the March 22 date that aggregates the expectations of all market participants. You can see how market prices converged due to improved information over time. What started as a wide range of expectations back in March 2022, gradually narrowed in months and weeks leading up to the March 23, 2023 announcement. However, over the course of the full period, incoming news in one way or another caused pricing bumps.
Exhibit 1: Markets Work to Help Predict Future Interest Rates
Range of participant expectations for March 2023 Federal Funds Rate, March 2022-March 2023
Source: CME Group. Market Implied Fed Funds Rate is based on probabilities of a given target Fed funds rate range from corresponding CME Group Fed Fund Futures Contracts. Range of Participant Expectations is the corresponding expected future interest rates where the probability is not zero.
You may be concerned that continued rate hikes could negatively impact your fixed income allocation’s total return. While forecasting the paths of interest rate change is largely educated guesswork, consider that higher yields resulting from continued change would mitigate fixed income capital losses incurred. Exhibit 2 is a matrix showing the impact of hypothetical rate increase scenarios on fixed income vehicles over longer maturities. Notably, even if rates increased by another 100 bps, a bond with a 7-year duration still could generate a 1.02% positive total return when held to maturity.
Exhibit 2: Evaluating Rate Increase Scenarios
Comparing 1-YR total returns for a range of maturities in different rate increase scenarios, initial yield of 5%
For illustrative purposes only. The matrix computes the realized total return for a bond with a 5% coupon rate paid annually and a 1-year holding period. The matrix illustrates the impact of a hypothetical interest rate change at the beginning of the holding period, for a given maturity, assuming a parallel shift in the curve. Data presented are based on mathematical principles, are not representative of indices, actual investments or actual strategies managed by Dimensional, and do not reflect costs and fees associated with an actual investment. Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Source: Dimensional.
The speed of U.S. interest rate hikes between March 2022 and May 2023 is the fastest increase in decades. Today, the Fed Fund’s Target Rate Range sits at 4.75%-5% after 25 basis point increases in February, March and April. While these recent bumps indicate a slower pace in rate rises compared to the dramatic series of rises during 2022, there is no reliable way to determine whether that trend will continue, or when it will decline.
What we know for sure is that markets will continue to set price expectations in real time. We also know that information using sophisticated risk management tools employed by Dimensional Fund Advisors target higher expected returns for client strategies. Coupling this approach with a variety of fixed income solutions having variable maturity approaches within informed investment management strategies can help you achieve your retirement income goals with greater confidence than playing a guessing game on your own.