Bond Markets and the Federal Reserve

1
Bond Markets and the Federal Reserve

• An Overview

2
Read the supplementary notes for Topic 2

• Supplementary Notes on the Federal Funds Rate
• Supplementary Notes on Long-Term Vs. Short-Term
  Treasury Yields

3
What is the federal funds rate?

• This is also called the fed funds rate (or,
  simply, the funds rate).
• The fed funds rate is an interbank interest rate
  the rate at which banks and other depository
  institutions borrow money from one another
  overnight.
• The fed funds rate is a market-driven rate, but
  its target is set by the Federal Reserve.
• The Fed keeps the fed funds rate close to the
  target rate by controlling the supply of funds
  available to banks. To do so, the Fed can employ
  the so-called open market operations whereby it
  buys and sells Treasury securities to increase or
  decrease the liquidity in the banking system.

4
Short-term bank rates

• The fed funds rate provides a base measure of a
  banks cost of short-term funds.
• Short-term interest rates offered at banks will
  move in sync with the fed funds rate. These
  rates include
• CD rates
• Money market rates
• Business loan rates
• Consumer loan rates

5
Short-term Treasury yields

• To offer bond investors competitive yields
  relative to bank CD rates and money market rates,
  short-term Treasury yields will move in line with
  those changes in bank rates.
• Accordingly, the Fed can control short-term bond
  rates by setting the target for the federal funds
  rate. In contrast, bond market traders have
  little influence over short-term bond rates.

6
Long-term Treasury yields

• Long-term interest rates (e.g., mortgage rates
  and corporate bond rates) are closely tied to
  long bond rates.
• Although long-term bond rates usually move in
  line with short-term bond rates, they do not
  always do so. As a result, the Federal Reserve
  has no direct control over long rates.
• Long-term bond rates are largely determined by
• Market expectations about inflation
• Market expectations about monetary policy.

7
Inflation expectations and bond yields

• Rising prices will make the buying power of your
  money lower in the future than what it is today.
  Since a bond can lock up your money for a long
  period of time and it provides fixed income only,
  a rising rate of inflation will eat away the
  bonds real return.
• When inflation is expected to go up, the demand
  for fixed-income securities such as bonds will
  drop, causing bond prices to fall and yields to
  rise. The higher yields serve to compensate for
  the higher expected inflation.
• Prices of longer-duration bonds tend to be more
  sensitive to inflation risk than those of
  short-duration bonds. With a longer duration,
  there is more time for things to go wrong,
  including greater uncertainty over inflation.

8
Monetary policy expectations and bond yields

• Although the Fed has no direct control over long
  rates, which are largely set by bond traders, the
  Fed can influence long rates indirectly by
  signaling its planned course of interest rate
  policy.
• If the Fed is expected to raise interest rates,
  existing bonds those paying the old, lower rate
  become less desirable compared to newer bonds
  that will be issued at a new, higher rate in the
  near future. Any investors who consider buying
  bonds will demand a higher yield (i.e., a lower
  price). As a result, existing bonds would drop
  in value when rates are expected to rise.
• An alternative explanation The expected
  interest rate hike would lower bond prices in the
  future. To reduce future losses, some investors
  would sell bonds now. Hence, existing bonds
  would fall in prices when interest rates are
  expected to rise.

9
SummaryDetermining factors for bond prices

• The fed funds rate target
• Bond prices (especially those of short-dated
  bonds) will fall with higher fed funds rates.
• Inflation expectations
• When inflation is expected to rise, investors
  will demand higher bond yields to make up for
  higher inflation, thus driving bond prices down
  (especially those of long-dated bonds).
• Monetary policy expectations
• When the Fed is expected to adopt a tightening
  policy and raise interest rates, investors will
  cut their bond holdings to reduce future losses,
  thereby sending bond prices lower (especially
  those of long-dated bonds).

10
Next subjectEconomic indicators for inflation
pressures

• To understand how market expectations on
  inflation are formed, we need to know how
  inflation pressures in the economy can be gauged.
• To gauge inflation pressures, market analysts
  constantly examine all newly released economic
  data and indicators following an economic
  calendar (see, e.g., http//biz.yahoo.com/c/e.html
  ).
• Monetary policy expectations also depend on
  inflation analysis. The intensity of Inflation
  pressures will determine how far and how fast the
  Fed raises interest rates.
• Policy statements and minutes of the Feds
  Federal Open Market Committee (FOMC) are also
  studied carefully by market analysts, traders,
  and investors to gain insights into the future
  course of monetary policy.