The reason for this is that the Federal Reserve has taken the financial markets into places it has never seen before. Thus, everybody is on “new” ground and everyone is just guessing about where the markets will go in the future. One can call current monetary policy the “Great Experiment” and market participants are just going to have to live with it!
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And, Federal Reserve officials are trying to tell the markets where they are going…something that has never been done before. This process of central bank communication is called “forward guidance.” The definition of “forward guidance: communication by a central bank aimed at signaling the likely future path of policy rates.
The “policy rate” of the Federal Reserve System is the federal funds rate, the interest rate that depository institutions actively trade balances held at the Federal Reserve. Historically, the Federal Reserve has conducted “short-term” monetary policy using a target federal funds rate or a range of federal funds rates as the “objective” of such policy.
Currently, the “policy range” for the federal funds rate has been set between a minimum zero interest rate and a maximum limit of 25 basis points. During 2013 the “effective” federal funds rate, the weighted average of market trades, has averaged below 15 basis points. In the last four months the average federal funds rate has been below 10 basis points.
This target range has been in effect since December 2008.
There is very little trading going on in this market because the banking system is “flush” with excess funds so there is very little demand for such borrowing.
Officials at the Federal Reserve have indicated that they believe the federal funds rate will remain low, at least out into late 2015…another two years or so!
In practice, the Federal Reserve can hold the federal funds rate to any target it sets. And, the federal funds rate strongly influences all other short-term interest rates.
This is why many analysts are advising investors to only invest in government securities that have maturities of five years or less. Government securities are assumed to have little or no credit risk…even given the current budget battles in the United States government. But they do have “interest rate risk,” the risk that interest rates…and hence bond prices will change.
Securities with maturities of five years and less have the smallest amount of interest rate risk…and hence, possess the characteristic that they will not decline in prices much in the near term, even if interest rates do rise.
Yes, government securities with maturities so short do not yield much interest, but it is assumed that falling security prices will not wipe out the entire yield that these maturities are producing. The evidence given against “going longer” at the present time is the damage falling bond prices have caused in the “total yield” on longer-maturity securities over the past four months.
This is new ground…and to some analysts, this central bank policy is causing a massive disconnect between what the current prices of financial assets and the fundamentals that exist in the financial markets and in the economy.
However, the future is not something that the Federal Reserve can control and this is one reason why central banks have never tried “forward guidance” before.
If the “forward guidance” turns out to be wrong, and market “expectations” are broken, then discontinuities can arise in financial markets as traders try and discern what the “new” expectations should be and what these expectations mean for current market prices.
Just note the discontinuity that arose in the financial markets once Ben Bernanke announced on
September 18 that the Federal Reserve would not begin to “taper” its purchases of US Treasury securities and mortgage-backed bonds. The bond market reacted immediately with a large, discrete drop in interest rates. Market expectations had been broken.
Yes, I know, Mr. Bernanke and other Federal Reserve officials had never stated that they would begin to “taper” purchases in September. But, because of things that Mr. Bernanke and other Federal Reserve officials did say, “expectations” about a “tapering” build up and were recorded in the prices of government securities. Mr. Bernanke and officials at the Federal Reserve seemed to be blind to this buildup.
So when market expectations are broken, prices move…and prices can move dramatically.
And, for the federal funds rate to remain at the current level for two or more years is, at best, a fantasy. Yes, the federal funds target has been in operation for almost five years. But, we have never seen anything like this.
And, this is creating a tremendous disconnect between the short-term end of the bond market and the longer-term end of the bond market. Over the past year, while short-term interest rates basically remained constant, the yields on longer-term securities rose dramatically. The yield on the 10-year Treasury bond rose by more than 130 basis points since December 2013, most of the rise started in the Spring of this year.
This rise, by the way, began before Mr. Bernanke even mentioned the possibility of the Fed tapering its purchases and seems to be more connected with the financial calm in the eurozone that resulted in European funds, planted in “safe haven” investments in the United States, returning back to the continent.
Since Mr. Bernanke “broke” expectations on September 18, the yield on the 10-year Treasury security has only dropped about 30 basis points, just a fraction of the rise earlier this year. And, unless European monies return to the “safe haven” United States, most believe, including myself, that yields on longer-term government bonds will go higher, with the 10-year rising above 3 percent.
In terms of investment strategy, investing in longer-term government securities is risky because of the possibility of long-term interest rates rising even further. Investing in maturities don’t provide much yield, but they are “safer” in the sense that they are shorter-term and they don’t contain as much “interest rate risk.” All one can say here is to be agile…be aware of changing directions.
As far as the Federal Reserve is concerned…we are in the middle of the “Great Experiment.” The Federal Reserve doesn’t know what it is doing; it doesn’t know what it is going to do; it doesn’t know when it is going to taper; and it doesn’t know whether “forward guidance” will work or not.
Don’t get me wrong. The Federal Reserve is exceedingly important when it comes to the performance of financial markets. That is just part of the problem investors face.
About John Mason
John has been the President and CEO of two publicly traded financial institutions and an Executive Vice President and CFO of a third. He has also spent time as an economist in the Federal Reserve System and worked for a cabinet secretary in Washington, D. C. In addition John taught in the Finance Department at the Wharton School of the University of Pennsylvania for ten years. He now currently has a column on the blog Seeking Alpha and is ranked number 3 in terms of readers on the economy. From this column, two books have been published this past year from earlier blog posts. John is active in the shadow banking world, the venture capital space, and in angel investing. Other than that John works with start ups and early stage organizations, for profit and not-for-profit.Want to learn how to generate more income from your portfolio so you can live better? Get our free guide to income investing here.