Federal Reserve

The Market Knows Best: Federal Reserve Raises Rates

Federal Reserve

Well there you have it folks. The Federal Reserve finally took action to increase the Federal Funds Rate. The catastrophe that was anticipated by many financial pundits ended up being what seemed like no news at all. How could this possibly be?

While many market participants were waiting on the sidelines to receive official news from the Federal Reserve, the market had already been moving in anticipation of the actual increase. Since the beginning of 2013, we have seen a steady increase in yields across an array of short term maturity treasuries. The chart below shows yield to maturity for 6-Month T-Bills, 1-Year US Treasury Notes, and 2-Year US Treasury Notes from January 2013 to the beginning of November 2015[i].

As you can see, the yield on the 2-Year Treasury has almost doubled since the beginning of this year alone, from 0.45% in January 2015 to almost 0.90% today. Further, the 6-Month US Treasury has risen from 0.03% in May to over 0.30% in November, which correlates almost perfectly with the 0.25% increase that the Federal Reserve announced in December.

Similarly, after the announcement of the increase by the Federal Reserve on December 16, 2015, there was no dramatic change in yields across US Treasuries of varying maturities. The chart below shows the intraday change in US Treasury Yields on December 16, 2015 for 2-Year US Treasuries, 5-Year US Treasuries, 10-Year US Treasuries, and 30-Year US Treasuries.

For the entire 24-hour period, yields stayed essentially “flat.” While many would anticipate a tremendous amount of volatility given the announcement, it is important to remember that the market is forward thinking. It is not concerned with what has happened but with what will happen. As Dimensional Fund Advisors so eloquently puts it, “the market was unsurprised and able to digest, without catastrophic loss, the first increase in the federal funds rate target since 2006.”[ii]

Now while the Federal Reserve has indicated there may be further rates hikes in the future, it is important for investors not to try and time this movement nor change their investment policy based on this anticipation. While many believe the Federal Reserve controls short-term rates, we can see from this example that the fixed income market was well ahead of the Federal Reserve in anticipating the increase. Participating in the timing of interest rate increases is no better than trying to time when stock prices are going to rise and fall. Further, waiting until news comes out before taking action will ultimately leave the investor chasing the past. The market had already moved on.

It is also important to note that not all maturities move in lock-step with each other when the Federal Reserve takes action. During the last go around of monetary tightening from 2004 to 2006, the Federal Reserve increased the federal funds target rate by 4.25%, but longer term maturities, like the 5 and 10 Year US Treasuries, had little to no change on their yields[iii]. The chart below shows the change in yields for the Fed Funds Target, 5-Year US Treasuries, and 10-Year US Treasuries from mid-2003 to the end of 2006.

Many investors may be thinking to sell-off their bond funds in anticipation of further increases; they may be doing more harm than good. The long term role that fixed income plays in portfolios is to dampen the significant volatility that we see in equities. Although rates have been slowly creeping up over the last 12-months, we have seen positive returns across all four of the bond funds we utilize in our IFA Index Portfolios, year-to-date. Markets are not as simple as we sometimes like to think, and while we expect interest rate hikes to decrease the value of the bonds in our portfolio, investors may still push up prices in anticipation of other macroeconomic events or changes in risk preferences.

We do not know for certain whether or not the Federal Reserve has complete control over interest rates, which happens to be a current topic of research for Nobel Laureate Eugene Fama[iv]. We do have real-time data showing the power the markets have in digesting information. Investors should forget trying to forecast the different outcomes that interest changes will have on their portfolio and instead focus on maintaining a long term asset allocation that matches their risk exposure with their risk capacity.

[i] Dimensional Fund Advisors, LP. The Rise of Short-Term Rates. November 2015.

[ii] Dimensional Fund Advisors, LP. Treasury Market Absorbs Fed’s Increase. December 2015.

[iii] Dimensional Fund Advisors, LP. Considering Central Bank Influence on Yields. September 2015.

[iv] Fama, Eugene. Does the Fed Control Interest Rates? University of Chicago, Booth School of Business. July 02, 2013.