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Market View

Investors in the front end of the yield curve already “own” future expected rate hikes.

 

In Brief

  • The key determinant of short-term rates is the expectation of future fed funds rates of the U.S. Federal Reserve (Fed)—not the fed funds rate today.
  • This point is critical, because it explains why short rates typically do not move much when the Fed announces a change in its target rate.
  • Investors in true short-maturity bonds, therefore, already “own” future expected rate hikes, and widely expected market events should not impact bond valuations in a significant way.

 

Chart 1. One-Year Treasury Bill Yields Reflect the Average of Expected Fed Funds Rates of the U.S. Federal Reserve

Source: Bloomberg. The information shown is for illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Market forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.
Past performance is not a reliable indicator or a guarantee of future results.

 

With another Federal Open Market Committee (FOMC) meeting and decision on interest rates looming (the FOMC is the U.S. Federal Reserve’s [Fed] policy-making assembly), investors may wonder, quite reasonably, how another rate hike might affect their portfolios. The short answer is, “not much,” because every stock and bond already has an expected rate hike priced into its current valuation. However, while the relationship between the fed funds rate and short-term interest rates is both rational and straightforward, there are a number of misconceptions about the true impact of Fed activity. Understanding how Fed actions truly affect short-term rates, and why movements in the fed funds rate often impact rates in seemingly counterintuitive ways, can go a long way to shining a light on the potential impact of future rate hikes.   

The Fed Funds Role as Policy Tool
First, a brief comment on the fed funds rate—what it actually is, and what happens when the Fed hikes the target rate. Banks are required to hold a certain percentage of deposits in reserve at the Fed. Any reserves a bank holds above the regulatory minimum are known as “excess reserves.” If the bank so chooses, it can keep excess reserves at the Fed and earn IOER (interest on excess reserves). Banks also have a second option—they may choose to lend excess reserves overnight to other banks looking to manage fluctuations in deposits without falling below any regulatory requirements. The fed funds rate is simply the rate at which banks can lend excess reserves to one another overnight. Finally, banks have the option to invest excess reserves in short-term U.S. Treasury bills: a “safe” and liquid alternative. As rational economic actors, banks will decide which of the three options would offer them the best return. Although the fed funds rate has no direct bearing on short-term Treasury market rates, because banks have the option to invest in either, the two rates display a very tight relationship.

The Key Driver of Short-Term Rates
An important nuance is that the key determinant of short-term rates, such as one- or two-year U.S. Treasury yields, is the expectation of future fed funds rates—not the fed funds rate today. For example, the current yield on a one-year Treasury bill should be close to the monthly average of expected fed funds rate over the course of the next year (Chart 1). This point is critical, because it explains why short rates typically do not move much when the Fed announces a change in its target rate. The only reason for interest rates to move is if expectations of future fed funds rates change, or if the Fed somehow acts in an unexpected way. For example, the Fed announced a rate hike on December 13, 2017, as expected. Two-year Treasuries yielded 1.83% on December 12, before the meeting, and 1.81% on December 14, after the meeting.  While yields have risen since the announcement on December 13, that move has been driven by subsequent revisions to the expected number of Fed hikes for the next two years (currently, the market expects an additional 2.1 hikes by the meeting on December 19, 2018).

What does this relationship between the fed funds rate and short-term interest rates mean for investors?  Simply put, it means that an investor in the front end of the yield curve already “owns” future expected rate hikes, and that any expected market event should not impact valuations in a significant way. In Chart 2, we can see what might happen if the Fed fails to hike as expected. Banks would earn less on their excess reserves, making an investment in Treasuries more appealing, ultimately driving short-term Treasury rates down and realigning them with expected fed funds rates. Investors who expect short-term Treasury rates  to rise in response to a Fed hike might also expect them to remain constant if the hike ultimately doesn’t occur. However, if the Fed surprises the market by failing to hike, yields on short-term bonds could actually fall. Whether investors are in bonds of ultra-short duration (i.e., less than six months) or in bonds with two years of duration, an expected hike should not affect valuations (though new information about the path of future moves might).

 

Chart 2. A Failure of the Fed to Hike in March Could Result in Falling Treasury Bill Yields

Source: Bloomberg. The information shown is for illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Market forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.
Past performance is not a reliable indicator or a guarantee of future results.

 

This concept can be used to illustrate the relationship between the expected fed funds rate over the course of two years and the yield on the two-year Treasury note as well (Chart 3).

 

Chart 3. Two-Year Treasury Bill Yields Reflect the Average of Expected Fed Funds Rates

Source: Bloomberg. The information shown is for illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Market forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.
Past performance is not a reliable indicator or a guarantee of future results.

 

As with all financial assets, changes in valuations come from changes in information. Markets are very efficient when it comes to pricing in widely available information. As a rule of thumb, investors in short-maturity bonds can think of themselves as already “owning” expected future Fed actions, or any expected earnings or economic data, through today’s prices of financial assets.

 

This article may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

All investments involve risks including possible loss of principal. Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that markets will perform in a similar manner under similar conditions in the future. 

Glossary of Terms

A bond yield is the amount of return an investor will realize on a bond. Though several types of bond yields can be calculated, nominal yield is the most common. This is calculated by dividing the amount of interest paid by the face value.

U.S. Treasuries are debt securities issued by the U.S. government and secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes. Although U.S. government securities are guaranteed as to payments of interest and principal, their market prices are not guaranteed and will fluctuate in response to market movements.

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett’s products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.

The opinions in Market View are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. The material is not intended to be relied upon as a forecast, research, or investment advice, is not a recommendation or offer to buy or sell any securities or to adopt any investment strategy, and is not intended to predict or depict the performance of any investment. Readers should not assume that investments in companies, securities, sectors, and/or markets described were or will be profitable. Investing involves risk, including possible loss of principal. This document is prepared based on the information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.

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