Last week, the Federal Reserve did what was expected by leaving their target for the fed funds rate unchanged. To the point that a misplaced adverb can cause a mini market selloff, investors meticulously dissect Federal Open Market Committee minutes and hang on Fed Chair Jerome Powell’s every word for language that provides insight into where the Fed may take interest rates. It’s a near universal axiom that the Fed sets interest rates, and we’re all just along for the ride.
How much control does it really have, though?
The bond markets are consistently accurate at pricing in what the Fed will do throughout the year. While the Fed does a good job being forthright about the state of the economy and its actions, this isn’t really a result of Jerome Powell saying all the right things in his speeches.
We have a quasi “chicken and the egg” scenario: does the Fed guide the bond market, or does the bond market lead the Fed?
Firstly, it’s not pedantic to point out the Fed doesn’t actually directly control the federal fund’s rate; they only set a target range for it, implemented typically very well, via open market operations (though sometimes this rate does get away from them). The only interest rate the Fed has 100% under its own control is the discount rate: the cost to borrow directly from the Fed itself. Neither of these are rates a normal person, or even a company, directly encounter. Both of these are overnight interbank lending rates banks incur to meet Fed-mandated reserve requirements.
Why does the Fed merely setting a range for a rate that’s only meant for banks borrowing from each other matter so much? There are ripple effects for the rates that end up manifesting in real life for companies and people. But a look at some of the data makes it less clear exactly who is influencing who. For this analysis, I’ll be using the research of renowned NYU professor of finance Aswath Damodaran, commonly known as the “Dean of Valuation” in the financial world.
The table below shows the most-recent bout of Fed tightening from 11/16 - 2/18 and the subsequent behavior of 3-month Tbills and 10-year Tbonds.
The Fed looks like it exerts effective control over short-term rates when it moves its target, as you see increases in Tbill rates consistent with the fed funds rate. However its control on long-term rates is not nearly as impactful. The overall movement is upwards, but you’ll note Tbond rates were sideways and even down slightly over the first 13 months of Fed tightening, only in the last two months do they become clearly higher than what they were over a year ago.
At first glance, it’s intuitive to conclude the Fed essentially controls very short-term rates, and struggles to manage long-term ones, but they eventually follow suit. However when we broaden the date range the Fed’s power is placed in better context.
Monthly data from 1962 - 2018 (see slide #5 in the linked research) demonstrates how interdependent the fed funds rate, Tbill, and Tbond rates are. When we assess how these rates behave within the same period, the Tbill and fed funds rate are related, moving together with an r-squared of 56.5% (meaning 56.5% of the change in one can explain the change in the other). However the relationship with Tbond’s is dramatically weaker, with an r-squared of only 6.7%.
So there's shared movement within the same period, however regarding the causality question: if the Fed is leading interest rates, a move in the fed funds rate ought to produce the same in Tbill and Tbond rates in the subsequent period. However you see the r-squared actually decrease when you compare the movement in interest rates the month after the fed funds rate is modified.
Further, when you invert the test to see if shifts in Tbill rates are what precipitate a move for the Fed, it’s actually more likely the fed funds rate will change based on what the Tbill rate did in the former period. It’s not incontrovertible evidence, but over the span of nearly 60 years, this does not suggest the Fed is the dictator of rates it’s believed to be.
So if bonds are largely deriving their prices independent of central body control, what’s driving them? Basic macroeconomics.
Expected inflation and GDP growth are what ultimately create interest rates. If you add up the expected inflation and growth rate, you get an intrinsic risk-free rate (in theory, what the 10-year Tbond rate would be without any Fed influence). Broken down by subperiod above, you can see over the last 60 years the intrinsic risk-free rate has been inextricably tied to the real risk-free rate (10-year Tbond).
Giving the Fed its due, this isn’t to say it has no effect. And that difference can be encapsulated by taking the difference between the 10-year Tbond rate and the intrinsic risk-free rate (The Fed Effect on the chart). Suffice to say this is a much more subdued impact than it’s routinely given credit for.
The bond market is a sage leading indicator because its market prices reliably reflect future economic growth expectations. The reason no one can consistently predict interest rates isn’t because no one can foretell what 12 economists in a room decide to do with them, it’s because the real driver of interest rates is a multivariate macroeconomic equation that no central body has real control over.
Rather than obsess over Fed decision making, the data suggests that you’re best suited to simply pay attention to inflation and growth to get an idea of where rates will head. It's high growth and expected inflation that give way to elevated interest rates, and vice versa.