With the Fed back on the path of cutting rates, it’s natural for investors to wonder how to play it. If their plans involve trading bonds in anticipation of a rate reduction, they’re better off focusing their energies elsewhere.
It might seem plausible to base a trading strategy on the fact that when yields go down on fixed-rate bonds, their prices go up. By that reasoning, bond prices should rise in response to a Fed rate cut.
The catch is that a reduction in the Fed funds rate (the rate that banks charge one another for overnight borrowing) directly affects only short-term money market rates. Long-term bond rates don’t necessarily have to follow.
You might even base your strategy on the proposition bond yields will go up when the Fed cuts short-term rates. After all, the Fed’s hoped-for effect is to stimulate the economy, which will in turn boost corporations’ demand for capital. Stepped-up bond issuance should drive bond yields up and bond prices down, rather than the reverse.
Fortunately, we don’t have to decide this question via a philosophical debate about what ought to happen. The historical record tells us what does happen in practice. The following analysis measures the change in the 10-year Treasury rate from one trading day before the announcement of a reduction in the Fed funds target rate to one week after it.
|10-Year Treasury Yield One-Week Response to Fed Rate Cut|
|Sources: ICE BAML Index System, Federal Reserve Bank of St. Louis|
In the most recent— and therefore most relevant— period, 2007-2018, betting on the bond market’s response to Fed rate cuts was essentially a 50/50 proposition. Treasury rates rose six times and fell four times. Even if you correctly foresaw that the Fed would lower its bench-mark rate, you were as likely to lose money as to make money by betting that bond yields would move in one particular direction following a Fed funds rate.
This isn’t really a surprising result. Nowadays, Fed governors drop strong hints in advance about their intentions. So rate cuts don’t really constitute news when they occur. Various other factors will therefore drive the post-announcement price action on bonds.
To round out the analysis, I broke down the years before 2007 into two sub-periods because of research indicating that the Fed began more openly telegraphing its intentions during the latter part of Alan Greenspan’s chairmanship. We might therefore expect that in the early Greenspan years, Fed rate cuts surprised the market more than in recent years. If so, those cuts would have genuinely represented news and the bond market likely would have responded to them in a consistent manner. The 1987-1992 results somewhat support that idea. But that sub-period’s preponderance of declining-yield responses may have been in reality the result of a sharp, continuing drop in Treasury yields in 1991.
1Roger W. Spencer, John H. Huston, and Erika G. Hsie, “The Evolution of Federal Reserve Transparency under Greenspan and Bernanke,” Eastern Economic Journal (September 2013), pp. 530-546