Reading Fed Tea Leaves? Watch Market Prices Instead


Fed watching is once again one of the markets’ favorite pastimes. Fed officials continue to signal that they would favor tapering of bond purchases in 2021, in line with recent announcements from the European Central Bank. When and how remain to be seen. With ample speculation about the Fed, unemployment, and inflation, it might be a good time for a reminder about what Fed announcements can, and cannot, tell us about the future of fixed income markets.

Yields reflect the aggregate expectations of all market participants, including opinions on how and when the Fed will act. And even if a crystal ball could reveal the timing and direction of the Fed’s actions, we would not know how broader interest rates would react. The Fed is one of many market participants in a larger ecosystem that impacts yield curves at large.
 

Fed Says ‘Jump,’ Market Says ‘Not So Fast’

At the Federal Open Market Committee meeting in July, Fed officials strongly suggested they would soon slow bond purchases, and they confirmed their intentions at the Jackson Hole Symposium in August. Fed Chair Jerome Powell announced that “a moderation in the pace of asset purchases may soon be warranted.”1 But fixed income markets have responded tepidly, perhaps because market participants already priced in a potential tapering. Exhibit 1 shows that interest rates generally decreased during the last three months, as opposed to increasing like they did when the Fed announced tapering in the wake of the Global Financial Crisis (“GFC”). This movement may suggest that market dynamics and participants in aggregate, not the Fed alone, determine the level and shape of the yield curve.
 

exhibit 1

Hop, Skip, or Jump: Always Aggregating Information

Treasury yield curve, May 31, August 31, and September 22, 2021

While shorter-term yields rose, longer-term yields fell, a reminder that longer-term yields do not always move in lockstep with changes in the federal funds target rate. Exhibit 2 shows there have been instances when the Fed increased the federal funds target rate, yet longer-term interest rates decreased. From January 1983 to December 2020, there were 70 months in which the federal funds rate increased. About a third of the time, the increase coincided with a decrease in the 10-year US Treasury yield. The lack of a consistent relation between movements in long-term yields and the federal funds rate reinforces the notion that yield curves reflect all available market information, including any Fed action.
 

exhibit 2

A Tenuous Relation

10-year US Treasury yield vs. federal funds target rate, January 1983-December 2020

1. In the United States, the federal funds rate refers to the rate that depository institutions charge each other for an uncollateralized overnight loan of funds. The Federal Reserve sets the target for this interest rate, though market forces can cause variation from the target rate at times.
 


Investors should not discount the importance of the Fed and its role in the global financial markets, however. The Fed has many powerful tools to simulate the economy during times of economic distress, as evidenced by its response to the GFC and the COVID-19 pandemic. Still, the Fed does not act in a vacuum. Prices across the broader yield curve are set in conjunction with the aggregate expectations of numerous other market participants.
 

No Reliable Way to Predict Future Interest Rates

Investors don’t need to dedicate time or resources to predicting the Fed’s next move. Rather, decades of empirical research provide a framework for understanding how to use information in market prices and diversification to pursue higher expected returns and improve the reliability of outcomes.

Larger differences in forward rates among bonds of different durations, credit qualities, or currencies of issuance can indicate larger differences in expected returns. Using market information available in global yield curves is a more reliable way to improve expected returns than trying to read the Fed’s tea leaves.
 

Footnotes

  1. 1Federal Reserve Issues FOMC Statement,” Federal Reserve, September 22, 2021.

Disclosures

This material is in relation to the US market and contains analysis specific to the US.

The information in this document is provided in good faith without any warranty and is intended for the recipient’s background information only. It does not constitute investment advice, recommendation, or an offer of any services or products for sale and is not intended to provide a sufficient basis on which to make an investment decision. It is the responsibility of any persons wishing to make a purchase to inform themselves of and observe all applicable laws and regulations. Unauthorized copying, reproducing, duplicating, or transmitting of this document are strictly prohibited. Dimensional accepts no responsibility for loss arising from the use of the information contained herein.

“Dimensional” refers to the Dimensional separate but affiliated entities generally, rather than to one particular entity. These entities are Dimensional Fund Advisors LP, Dimensional Fund Advisors Ltd., Dimensional Ireland Limited, DFA Australia Limited, Dimensional Fund Advisors Canada ULC, Dimensional Fund Advisors Pte. Ltd., Dimensional Japan Ltd., and Dimensional Hong Kong Limited. Dimensional Hong Kong Limited is licensed by the Securities and Futures Commission to conduct Type 1 (dealing in securities) regulated activities only and does not provide asset management services.

UNITED STATES: Dimensional Fund Advisors LP is an investment advisor registered with the Securities and Exchange Commission.

Investment products: • Not FDIC Insured • Not Bank Guaranteed • May Lose Value
Dimensional Fund Advisors does not have any bank affiliates.

CANADA: These materials have been prepared by Dimensional Fund Advisors Canada ULC. They are provided for educational purposes only, should not be construed as investment advice or an offer of any security for sale and do not represent a recommendation of any particular security, strategy or investment product. Commissions, trailing commissions, management fees, and expenses all may be associated with mutual fund investments. Unless otherwise noted, any indicated total rates of return reflect the historical annual compounded total returns, including changes in share or unit value and reinvestment of all dividends or other distributions, and do not take into account sales, redemption, distribution, or optional charges or income taxes payable by any security holder that would have reduced returns. Please read the prospectus before investing. Mutual funds are not guaranteed, their values change frequently, and past performance may not be repeated.

AUSTRALIA and NEW ZEALAND: This material is issued by DFA Australia Limited (AFS License No. 238093, ABN 46 065 937 671). This material is provided for information only. No account has been taken of the objectives, financial situation or needs of any particular person. Accordingly, to the extent this material constitutes general financial product advice, investors should, before acting on the advice, consider the appropriateness of the advice, having regard to the investor’s objectives, financial situation and needs. Investors should also consider the Product Disclosure Statement (PDS) and the target market determination (TMD) that has been made for each financial product either issued or distributed by DFA Australia Limited prior to acquiring or continuing to hold any investment. Go to au.dimensional.com/funds to access a copy of the PDS or the relevant TMD. Any opinions expressed in this material reflect our judgement at the date of publication and are subject to change.

WHERE ISSUED BY DIMENSIONAL IRELAND LIMITED OR DIMENSIONAL FUND ADVISORS LTD.
Neither Dimensional Ireland Limited (Dimensional Ireland) nor Dimensional Fund Advisors Ltd. (Dimensional UK), as applicable (each an “Issuing Entity,” as the context requires), give financial advice. You are responsible for deciding whether an investment is suitable for your personal circumstances, and we recommend that a financial adviser helps you with that decision.

NOTICE TO INVESTORS IN SWITZERLAND: This is an advertising document.

WHERE ISSUED BY DIMENSIONAL IRELAND LIMITED
Issued by Dimensional Ireland Limited (Dimensional Ireland), with registered office 10 Earlsfort Terrace, Dublin 2, D02 T380, Ireland. Dimensional Ireland is regulated by the Central Bank of Ireland (Registration No. C185067). Information and opinions presented in this material have been obtained or derived from sources believed by Dimensional Ireland to be reliable, and Dimensional Ireland has reasonable grounds to believe that all factual information herein is true as at the date of this document.

Dimensional Ireland issues information and materials in English and may also issue information and materials in certain other languages. The recipient’s continued acceptance of information and materials from Dimensional Ireland will constitute the recipient’s consent to be provided with such information and materials, where relevant, in more than one language.

WHERE ISSUED BY DIMENSIONAL FUND ADVISORS LTD.
Issued by Dimensional Fund Advisors Ltd. (Dimensional UK), 20 Triton Street, Regent’s Place, London, NW1 3BF. Dimensional UK is authorised and regulated by the Financial Conduct Authority (FCA). Information and opinions presented in this material have been obtained or derived from sources believed by Dimensional UK to be reliable, and Dimensional UK has reasonable grounds to believe that all factual information herein is true as at the date of this document.

Dimensional UK issues information and materials in English and may also issue information and materials in certain other languages. The recipient’s continued acceptance of information and materials from Dimensional UK will constitute the recipient’s consent to be provided with such information and materials, where relevant, in more than one language.

RISKS
Investments involve risks. The investment return and principal value of an investment may fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original value. Past performance is not a guarantee of future results. There is no guarantee strategies will be successful.

JAPAN: Provided for institutional investors only. This document is deemed to be issued by Dimensional Japan Ltd., which is regulated by the Financial Services Agency of Japan and is registered as a Financial Instruments Firm conducting Investment Management Business and Investment Advisory and Agency Business. This material is solely for informational purposes only and shall not constitute an offer to sell or the solicitation to buy securities or enter into investment advisory contracts. The material in this article and any content contained herein may not be reproduced, copied, modified, transferred, disclosed, or used in any way not expressly permitted by Dimensional Japan Ltd. in writing. All expressions of opinion are subject to change without notice.

Dimensional Japan Ltd.
Director of Kanto Local Finance Bureau (FIBO) No. 2683
Membership: Japan Investment Advisers Association

FOR PROFESSIONAL INVESTORS IN HONG KONG.
This material is deemed to be issued by Dimensional Hong Kong Limited (CE No. BJE760) (“Dimensional Hong Kong”), which is licensed by the Securities and Futures Commission to conduct Type 1 (dealing in securities) regulated activities only and does not provide asset management services.

This material should only be provided to “professional investors” (as defined in the Securities and Futures Ordinance [Chapter 571 of the Laws of Hong Kong] and its subsidiary legislation) and is not for use with the public. This material is not directed to any person in any jurisdiction where (by reason of that person’s nationality, residence, or otherwise) the publication or availability of this material are prohibited or which would subject Dimensional Hong Kong (including its affiliates) or any of Dimensional Hong Kong’s products or services to any registration, licensing, or other such legal requirements within such jurisdiction or country. When provided to prospective investors, this material forms part of, and must be provided together with, applicable fund offering materials. This material must not be provided to prospective investors on a standalone basis. Before acting on any information in this material, you should consider whether it is suitable for your particular circumstances and, if appropriate, seek professional advice.

Unauthorized copying, reproducing, duplicating, or transmitting of this material are prohibited. This material and the distribution of this material are not intended to constitute and do not constitute an offer or an invitation to offer to the Hong Kong public to acquire, dispose of, subscribe for, or underwrite any securities, structured products, or related financial products or instruments nor investment advice thereto. Any opinions and views expressed herein are subject to change. Neither Dimensional Hong Kong nor its affiliates shall be responsible or held responsible for any content prepared by financial advisors. Financial advisors in Hong Kong shall not actively market the services of Dimensional Hong Kong or its affiliates to the Hong Kong public.

SINGAPORE
This material is deemed to be issued by Dimensional Fund Advisors Pte. Ltd., which is regulated by the Monetary Authority of Singapore and holds a capital markets services license for fund management.

This advertisement has not been reviewed by the Monetary Authority of Singapore. This information should not be considered investment advice or an offer of any security for sale. All information is given in good faith without any warranty and is not intended to provide professional, investment, or any other type of advice or recommendation and does not take into account the particular investment objectives, financial situation, or needs of individual recipients. Before acting on any information in this material, you should consider whether it is suitable for your particular circumstances and, if appropriate, seek professional advice. Dimensional Fund Advisors Pte. Ltd. does not accept any responsibility and cannot be held liable for any person’s use of or reliance on the information and opinions contained herein. Neither Dimensional Fund Advisors Pte. Ltd. nor its affiliates shall be responsible or held responsible for any content prepared by financial advisors.