FOMC: Changed Forward Guidance
By Steve Van Order, Fixed Income Strategist
Today the FOMC changed its forward guidance for target interest rates. A change in bond market expectation for the timing of the first rate hike pushed the short-intermediate maturity (i.e., three- to five-year) Treasury yields relatively higher than other maturities.
QE Taper to Continue
The QE was reduced by another $10 billion, to $55 billion per month, exactly as expected. The FOMC continued to guide markets to expect $10 billion of tapering to be announced per meeting. At this pace the program will be essentially completed by the end of October. This has been baked into the yield curve cake for some months now.
Changed Guidance on the Policy Target Rate
The forward guidance on the near-zero Fed funds rate target was changed. The two numerical thresholds (the 6.5% unemployment rate and 2.5% forecast inflation rate) were dropped. The Fed has formally returned to consulting broad array of indicators in evaluating the economy. (In our last FOFI we discussed Fed Chair Yellen's favorite labor market indicators.) The Fed expects to keep the Fed funds target rate near zero "for a considerable time" after the QE is finished. This decision was much as expected. One interesting wrinkle was explicitly using the end of the QE as the starting point for the countdown to the first rate hike.
At Fed Chair Yellen's press conference after the meeting a reporter wanted to know how long might be "a considerable time?" In response, the Fed chief speculated that it might mean "something on the order of six months or that type of thing." Forget any qualifying remarks, the markets quickly did the arithmetic and concluded she had signaled that rate hikes would start before summer of next year. This would be several months sooner than what the market had been expecting.
Even before Ms. Yellen's remark, the markets had digested the FOMC's new projections and saw higher expected Fed funds targets for the end of 2015 and 2016. For example, the projections showed a median 2.25% Fed funds rate at the end of 2016, a half-point higher than was projected in December. Lest we forget, however, a 2.25% Fed funds target rate would be well below the FOMC's long-run neutral level of 4%. This disparity underscores Fed guidance that the policy target rate will be quite low for a long time to come.
A More Normal Reaction in the Yield Curve
But, with today's interest rates very low because of Fed policy, markets obsess about when the Fed will start to end the party. Ms. Yellen's message signaled that the party might start to end somewhat sooner than expected. In reaction, the interest rates traditionally most sensitive to a change in monetary policy popped higher. Fed funds futures rates and yields on Treasuries maturing in the three- to five-year area, increased by 12-25 basis points depending on the instrument. Yields on ten- to 30-year Treasuries, in contrast, were up by plus or minus five basis points. This re-shaping of the yield curve is a classic response when the expected timing of Fed rate hikes is moved forward.
Looking ahead, with the QE tapering on near-autopilot markets will react to, or challenge, the Fed by pushing around yields on these short-intermediate maturity instruments. This is a healthier return to more traditional bond market behavior. It is evidence of the normalization expectation in markets with regard to expected economic growth and monetary policy over the next few years.
This commentary represents the opinions of the author as of March 20, 2014 and may change based on market and other conditions. These opinions are not intended to forecast future events, guarantee future results, or serve as investment advice. The statistics have been obtained from sources believed to be reliable, but the accuracy and completeness of this information cannot be guaranteed. Neither Calvert Investment Management, Inc. nor its information providers are responsible for any damages or losses arising from any use of this information. Calvert may have acted upon this research prior to or immediately following publication. In addition, accounts managed by Calvert Investment Management, Inc. may or may not invest in, and Calvert is not recommending any action on, any companies listed.