Given the recent rise in long term interest rates, the gush of
money flowing out of bond funds, and high expectation for the
Federal Reserve to start tapering its large scale asset purchase
program, I was prompted to refresh my memory on the actual
pricing of a change in the federal funds rate, the Fed's primary
tool for changing monetary policy. Let's review what
is going on with monetary policy and look at a few indicators
which could signal a shift in the Federal Reserve's interest rate
The Fed is widely expected to announce a $10 to $15 bln
tapering of its large scale asset purchase program on September
after its FOMC meeting. The Fed is likely to embark on a
program of gradual withdraw of purchases into 2014. The
idea of taper is well discussed and mostly likely priced by
The Fed's statement on short rates:
In its September 18
statement, the Fed is likely to reiterate its desire to keep
rates low for a long period. The statement from the last
FOMC announcement highlighting the committee's desire to keep
rates low for a prolonged period was: "
In particular, the Committee decided to keep the target range
for the federal funds rate at 0 to 1/4 percent and currently
anticipates that this exceptionally low range for the federal
funds rate will be appropriate at least as long as the
unemployment rate remains above 6-1/2 percent, inflation between
one and two years ahead is projected to be no more than a half
percentage point above the Committee's 2 percent longer-run goal,
and longer-term inflation expectations continue to be well
anchored. In determining how long to maintain a highly
accommodative stance of monetary policy, the Committee will also
consider other information, including additional measures of
labor market conditions, indicators of inflation pressures and
inflation expectations, and readings on financial developments.
When the Committee decides to begin to remove policy
accommodation, it will take a balanced approach consistent with
its longer-run goals of maximum employment and inflation of 2
What will traders watch?
Traders will be looking at two factors when assessing the
impact of policy on the markets. 1) How quick will the Fed
taper. The Fed currently buys $85 bln a month split $45 bln
in long term treasures and $40 bln in mortgage securities.
2) The Fed's statements relating to the federal funds rate.
Answering question 1:
It's anybody's guess, but my view rests in the Fed finishing
up with its treasury buying by the end of the year and then
starting to work on scaling back MBS purchases in 2014. The
Treasury is cutting coupon sizes, there are concerns the Fed is
hurting liquidity in the treasury market, and the housing market
could use more time to strengthen give the recent rise in
mortgage rates. The market may fret a little about the pace of
withdrawal, but for the most part the trade is expecting the Fed
to methodically end the program. The benefit of the program has
been limited given a paper published by the San Francisco
The wild card is the announcement of a new Fed Chair. Recent
press reports give the edge to Larry Summers over Janet Yellen,
but worries over Summer's Senate confirmation have kept Yellen in
the race. Summers is viewed as more hawkish and Yellen more
dovish. Their influence or the view of another new Fed Chair
could quicken or slow the pace of taper.
Answering question 2:
The more important question for the market rests in the timing
of an actual increase in the Fed's traditional policy tool, the
fed funds rate. A change in short term interest
rates would start to reshape the investment landscape; however,
the Fed is likely to go out of its way to reduce expectations of
higher short term rates in the near term. Unemployment is
still too high for the Fed's liking and inflation is a bit too
Higher short term rates could start to change profitability in
the banking system, change the investment outlook for holding
bonds, and cause traders to rethink the composition of their
equity portfolios. To this point, the "zero" rate
environment has been an easy reason to be bullish stocks and
bonds, although higher short rates don't need to lead to lower
stock and bond prices.
Despite the Fed's desires, the markets are likely to push the
Fed into lifting interest rates. Historically, the Fed has
lagged the market in setting policy. Signs of a vibrant
economic recovery or rising inflation would cause investors to
demand a greater return for holding fixed income assets and push
the Fed to adjust policy. In this spirit, the table
following highlights the spread between the 2 year treasury note
and the fed funds target and the spread between 3 month LIBOR and
the fed funds target in the week before the Fed raises the funds
target. The data goes back to 1987.
(Click to enlarge)
On a side note, the fed funds target rate was suspended just
after the stock market crash in 1987, and nudged slightly higher,
1/8%, in December 1986. This was not accounted for in the
table. The spread between the 2 year yield and fed funds
target before this snugging was 0.74% the week before the rate
The 2 Year - Fed Funds Spread:
(Click to enlarge)
The Fed has hiked the fed funds when the spread has averaged
1.10%. The largest spread was 1.77% in 2004, while the
narrowest spread was 0.94% in 1999. Note the funds rate was hiked
25 bps in four cases, and 50 bps in one case. The spread
was 1.24% when the Fed lifted rates by 50 bps.
The current spread is about 0.18% and suggests the Fed is far
from lifting the fed funds rate. When the spread gets
around 1.00% and the 2 year treasury yields starts trading around
1.25%, the Fed is likely to on the cusp of tighten monetary
policy. One could argue that the Fed will move faster this
time because of the abundance of liquidity in the system.
Maybe, but I'm sticking with the table for guidance. The
market knows the liquidity situation just as well as anybody
3 Month LIBOR - Fed Funds Spread:
The Fed has hiked the fed funds rate when this spread has
averaged 0.42%. The largest spread was 0.84% in 1987, while the
narrowest spread was 0.13% in 2004. If the average holds
true in the current cycle, 3 month LIBOR would have to be 0.67%
for the Fed to lift rates.
(Click to enlarge)
The current spread is near 0% and like the 2 year treasury
suggests the Fed is far from lifting the fed funds rate.
Higher rates are not all bad for stocks:
The graphic following displays the relationship between the
relative performance of the BKX, KBW Bank Index, to the S&P
500 via the S&P 500 ETF (
). There are plenty of periods where bank stocks
outperformed the general market when the 5 year treasury yield
was rising relative to the fed funds rate. The 5 year yield
was used to amplify the rise in interest rates and the market's
pricing of Fed tightening.
(Click to enlarge)
The next chart illustrates the relationship between the 5 year
treasury yield and the BKX (banks) outright. Notice that
the relationship is mixed over time. Higher rates helped
the bank sector between 2003 and early 2007. The direction
of rates has also positively correlated to the price of the BKX
since the end of the Great Recession. The picture is less
clear in the 1990's.
(click to enlarge)
The Fed is likely to slow its purchase of long term assets,
and will wind down the program in the coming months.
However, the action is far from a material tightening of monetary
policy and the Fed's normal policy measures, the fed funds rate,
is likely to remain low into 2014.
A change in rate policy will be on the horizon when the 2
year treasury yield and 3 month LIBOR rate start rising in a
. A rise in market rates may be a good indicator of future
Fed policy changes. Given history, the markets, not the Fed, are
likely to lead the rate hike process. The Fed will
test its policy change against market expectations.
Although there is some fear in the stock market over rising
rates, the bank sector has been able to benefit from rising rates
a number of times. This suggests Fed tightening does not have to
derail the bull market.
ISHARS-7-10YTB (IEF): ETF Research Reports
SPDR-KBW BANK (KBE): ETF Research Reports
SPDR-SP 500 TR (SPY): ETF Research Reports
ISHARS-20+YTB (TLT): ETF Research Reports
SPDR-FINL SELS (XLF): ETF Research Reports
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