Watching Fed Announcements? Watch Market Prices Instead

Fed watching is a pastime of many investors. Fed officials recently signaling that they favor tapering of bond purchases in 2021, in line with announcements from the European Central Bank, has captured considerable attention from those watchers. With ample speculation about the Fed, unemployment, and inflation in the media, we should remember what Fed announcements can, and cannot, tell us about the future returns of fixed income markets.

We learn from economic science that yields reflect the aggregate expectations of all market participants, including the collective opinions on how and when the Fed will act. And even if some magic crystal ball could reveal the timing and direction of the Fed’s actions, the much broader and longer-term interest rates reactions such as with corporate bonds would still be unknowable. The Fed is one of many market participants in a very large financial ecosystem that impacts yield curves for markets globally.

Fed Says ‘Jump,’ Market Says ‘Not So Fast’

Since the Covid lockdowns, the Federal Reserve took a variety of actions to help improve market functionality — including cutting rates, rolling out several lending programs, and purchasing Treasury and mortgage-backed bonds. As inflation began to rise recently, they began reversing those programs.

At July’s Federal Open Market Committee meeting, Fed officials strongly suggested they would soon slow bond purchases. They confirmed those intentions at the Jackson Hole Symposium in August where Fed Chair Jerome Powell announced that “a moderation in the pace of asset purchases may soon be warranted.”1 But fixed income markets responded tepidly to that announcement — perhaps because market participants had already priced in a potential tapering that anticipated the announcement.

Exhibit 1 shows that interest rates generally decreased during that three-month period, as opposed to increasing as they did when the Fed announced tapering in the aftermath of the Global Financial Crisis (“GFC”). This movement illustrates how market dynamics and its participants—not the Fed alone by itself—determine the actual level and shape of the yield curve. While shorter-term yields rose, longer-term yields fell, a reminder that longer-term yields do not always move in lockstep with changes in the federal funds target rate.

Exhibit 1: Hop, Skip, or Jump: Always Aggregating Information
Treasury yield curve, May 31, August 31, and September 22, 2021

Graph,Treasury yield curve, May 31, August 31, and September 22, 2021

Exhibit 2 also shows instances when long-term interest rates decreased when the Fed increased the short-term federal funds target rate. From January 1983 to December 2020, there were 70 months in which the federal funds rate increased. About a third of the time, the increase coincided with a decrease in the 10-year US Treasury yield. The lack of a consistent relation between movements in long-term yields and the federal funds rate reinforces the notion that yield curves reflect all available market information, including any anticipated Fed action.

Exhibit 2: A Tenuous Relation
10-year US Treasury yield vs. federal funds target rate, January 1983 – December 2020

Graph, 10-year US Treasury yield vs. federal funds target rate, January 1983 – December 2020

In the United States, the federal funds rate refers to the rate that depository institutions charge each other for an uncollateralized overnight loan of funds. The Federal Reserve sets the target for this interest rate, though market forces can cause variation from the target rate at times.

Investors should not discount the importance of the Fed and its role in the global financial markets, however. The Fed has many powerful tools to simulate the economy during times of economic distress, as evidenced by its response to the GFC and the COVID-19 pandemic lockdowns. Still, the Fed does not act in a vacuum. Prices across the broader yield curve are set in conjunction with the aggregate expectations of numerous other market participants involving other information.

Recent Fed Announcements

The Federal Reserve bought $4 trillion of bonds since the pandemic lockdowns began, with half of the buying occurring in the first three months of the crisis and about $120 billion a month since — $80 billion in Treasuries and $40 billion in mortgage-backed bonds. By the time the program will have ended, the Fed’s balance sheet will stand at just over $9 trillion, twice its pre-pandemic size.2

The Federal Reserve announced on Wednesday, November 3rd that it will begin scaling back the pace of its monthly bond purchases, confirming what many watchers were expecting.3 The process will see reductions of $15 billion each month – $10 billion in Treasuries and $5 billion in mortgage-backed securities and came shortly after Chairman Powell suggested “I do think it’s time to taper, and I don’t think it’s time to raise rates.”4 The contrary announcement to taper, really isn’t news for investors as we watch in the Exhibit how prices actually change over time compared to official Fed pronouncements.

No Reliable Way to Predict Future Interest Rates

Investors don’t need to waste time or resources to predicting a Fed’s move. Rather, decades of empirical research provide a framework for understanding how information in market prices and diversification may be used to pursue higher expected returns and improve reliability of outcomes for planning.

The lack of a consistent relation between movements in long-term yields and the federal funds rate reinforces the notion that yield curves reflect all available market information, including Fed actions.

Differences in forward rates among bonds of different durations, credit qualities, or currencies of issuance impact differences in expected returns. Using market information available in global yield curves in a smart process can be a more reliably enhance expected returns than futilely outguessing the Fed or the bond markets, or alternatively, simply settling for the lower returns of an index approach.

FOOTNOTES

1“Federal Reserve Issues FOMC Statement,” Federal Reserve, September 22, 2021.

2https://www.reuters.com/business/feds-bond-buying-timeline-roaring-entry-boring-exit-2021-11-02/

3https://www.wsj.com/articles/fed-dials-back-bond-purchases-plots-end-to-stimulus-by-june-11635962417

4https://www.wsj.com/articles/fed-chairman-jerome-powell-says-supply-side-constraints-are-creating-more-inflation-risk-11634917630?mod=article_inline