As the Federal Reserve tries to put the brakes on inflation in the US economy, the central bank has been employing one of its chief tools: its ability to set short-term interest rates (sometimes referred to collectively as the “Fed funds rate”). With increases in interest rates—which are effectively the “cost of money”—the intent is to decrease the rate of growth in the economy (a principal cause of inflation) by making it more expensive for companies and individuals to borrow, thus tapping the brakes on the economy and (hopefully) bringing inflation back to a more acceptable range without pushing the economy into a recession.
However, recent aggressive increases in interest rates by the Federal Reserve have roiled bond markets, both in the US and internationally. Analysts have begun to worry that the Fed’s economic “tranquilizer” could actually bring on a recession. As a result, many bond investors, who are seeking both security of their income stream (in the form of interest payments) and appreciation in the value of their bonds, may be wondering if there is a way to more accurately predict future price movements in bonds in order to increase total returns.
Recently, analysts at Dimensional Funds collected data on bond futures pricing from 1989 to the present. Federal funds futures are liquid monthly futures contracts that investors use to bet on or hedge against short-term interest rate fluctuations. Their prices are directly linked to the daily effective federal funds rate over a calendar month. For example, the June 2022 federal funds futures contract, which settled on July 1, 2022, had a settlement price based on the average daily effective federal funds rate of 1.21% for the month of June. Hence the price on a federal funds futures contract reflects the expected average federal funds rate for its settlement month. Because Fed fund futures capture market participants’ aggregate expectations of the future evolution of the federal funds rate, the researchers wanted to analyze the correlation between investors’ expectations for the future direction of fed funds rates and future bond performance.
By reviewing federal funds futures pricing for twelve consecutive months in contrasting periods, it is possible to visualize how investors’ expectations for future pricing change with alterations in market conditions.
The bottom line represents investors’ expectations for future Fed funds rates for the twelve months beginning in June 2020, two months after the beginning of the pandemic, and the top, curved line represents those same expectations for the twelve months beginning in June 2022, when inflation was beginning to ramp up. As you can see, investors’ expectations for changes in interest rates during the earlier period were for low rates that were flat to declining, while two years later, those expectations are quite different.
But do these expectations have any material effect on the long-term performance of bond portfolios? When analysts compared the market expectation of the federal funds rate change over a month and government bond performance in the subsequent month, they found no statistically reliable relationship between the two indicators. Further, when they compared market expectations for Fed funds futures with changes in term premiums (the pricing differential for longer-term bonds), they again discovered no reliable correlation between the two.
What all this suggests is that expected changes in the federal fund rates on current market prices of federal funds futures do not have forecasting power for future bond returns and term premiums. This is not surprising, since the federal funds rate is just one of many factors in global fixed income markets driving bond returns across different currencies and durations.
However, there is a robust way for investors to target higher expected returns in fixed income: by systematically varying their duration and currency allocation based on current term spreads across yield curves. In other words, the key to superior returns in a fixed-income portfolio may lie with our old friend, “diversification.”
At Empyrion Wealth Management, we know that for many investors, the relative stability and security of fixed income is a vital part of structuring income for a satisfying retirement lifestyle. Our goal is to provide the guidance and research you need to build the investing strategy that is right for you. To learn more, click here to read our article, “Retirement Investing during Volatile Times: A Measured Approach.”
Stay Diversified, Stay YOUR Course!