Aug 13, 2021

U.S. policy rate expectations: who is surprised?

Markets are following the Fed members view on policy rates in the long run pretty closely. They don’t call for a huge sell-off in 10-year treasuries.

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In 2005, Alan Greenspan, the then long-serving Chairman of the U.S. Federal Reserve (Fed), spoke about a puzzle in the markets (the so called conundrum):

The persistence of low yields on 10-year Treasury bonds despite the fact that the Fed funds rate had been increased by 150 basis points. Again today, some are asking the same question:

Is the market acting irrationally when 10-year Treasury yields stand at 1.3%, despite a strong economic upswing?



Some analysts may point to the massive bond purchases by central banks: they have provided additional demand that has depressed yield levels. However, there is another way of looking at it, though central-bank policy again plays an important role.

Investors in the bond market are always faced with the choice between investing funds for the long term by buying bonds with long maturities, or investing only for the short term and reinvesting maturing funds. Which of the two strategies yields a higher return depends on the development of short-term interest rates, which in turn are determined by the central bank's interest-rate policy.

Central banks strive for transparency and provide the public and investors with a wide range of information to help forecast monetary policy. The U.S. Federal Reserve, for example, publishes once a quarter the (anonymized) forecasts of members of the Open Market Committee on the development of the key interest rate, both for the coming couple of years and for the long term. For the bond market, this is highly relevant data, feeding into its own expectations of interest-rate developments, and these expectations ultimately result in concrete investment decisions.

As our Chart of the Week shows, interest-rate expectations priced into the market (known as "forwards") for a one-year maturity nine years from now have fluctuated in recent years around forecasts for Fed policy rates for the long, or roughly 10-year, term.

We think the current level is too low and expect yields to rise.

Since the sharp decline in the overall yield curve in early 2020, and thus in forwards, there has been an upward movement since mid-2020 that pushed slightly above FOMC members' long-term forecasts earlier this year. Since the second quarter of the current year, however, yields have fallen again. Some see this as evidence of growing skepticism about the long-term potential growth of the United States, but we think this short-term slump is mainly due to a sharp decline in the supply of new Treasuries[1] and the very unbalanced positioning of institutional market participants. We think the current level is too low and expect yields to rise. However, fears that 10-year yields could shoot up to three percent seem too pessimistic against the backdrop of long-term key interest-rate expectations of 2.5%.

Perhaps the central bank itself has solved Alan Greenspan's conundrum by means of its own guidance.

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1. The Treasury's cash balance at the Fed has decreased by roughly USD 1 trillion U.S. dollars since the beginning of the year, thereby reducing the amount of Treasury supply needed.

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