Federal Reserve interest rate decisions play a significant role in the bond market as the central bank’s monetary policy impacts prices and yields.
Bond exchange-traded funds, such as the iShares 20+Year Treasury Bond ETF (TLT), have become popular trading vehicles for investors expecting to profit from price gains associated with rate cuts (bond prices have an inverse relationship with interest rates and bond yields).
Learn how Fed rate decisions and its quarterly “dot plot” affect the bond market and specifically bond ETFs.
What Is the FOMC and How Does It Impact Interest Rates?
The FOMC, or Federal Open Market Committee, is a powerful group within the Federal Reserve System that plays a critical role in setting monetary policy for the U.S. The FOMC’s decisions to raise or lower the target federal funds rate and other monetary policy tools influence interest rates throughout the U.S. economy. These actions affect borrowing costs, economic activity and inflation.
Here’s how the FOMC impacts interest rates:
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FOMC Members: The FOMC consists of voting members including the Chair of the Federal Reserve Board, Jerome Powell, the President of the Federal Reserve Bank of New York, John C. Williams, and a rotating group of other Reserve Bank presidents.
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The FOMC’s role: Their primary responsibility is to conduct monetary policy by setting the target federal funds rate. This is the interest rate at which banks borrow and lend reserves to each other overnight. It’s a key benchmark that influences other short-term interest rates in the economy.
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The Fed’s dual mandate: The Federal Reserve has two key objectives, which are maximum employment and price stability. The former aims to promote a healthy job market by keeping unemployment at a low level while the latter focuses on controlling inflation and maintaining stable prices for goods and services over the long term.
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FOMC meetings: The FOMC holds meetings eight times a year to assess economic conditions and determine the appropriate target federal funds rate.
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Raising the rate: If the economy is overheating or inflation is rising, the FOMC might raise the target rate. This makes borrowing more expensive, which can slow down economic activity and dampen inflation. Banks typically raise their lending rates (mortgages, car loans, etc.) in response to a higher federal funds rate.
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Lowering the rate: Conversely, if the economy is weak or facing deflation, the FOMC might lower the target rate. This encourages borrowing and spending, stimulating economic growth. Banks tend to lower their lending rates when the federal funds rate is reduced.
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Open market operations: Buying and selling government bonds in the open market can affect short-term interest rates and the money supply.
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Forward guidance: Publicly communicating the FOMC’s future intentions regarding interest rates can impact investor expectations and market sentiment.
What Is the Fed’s ‘Dot Plot?’
The Fed’s dot plot, formally called the Summary of Economic Projections (SEP), is a visual representation of the individual forecasts of FOMC members for the future path of the federal funds rate. The Fed’s dot helps investors and businesses anticipate the Fed’s policy direction and make informed economic decisions.
Here’s a breakdown on how the dot plot works:
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What it shows: The dot plot displays each FOMC member’s prediction for the appropriate level of the federal funds rate at the end of each calendar year for the next few years (typically three) and the longer run (beyond that timeframe). Each dot represents an individual member’s forecast, and their placement on the vertical axis signifies the predicted federal funds rate.
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Why it matters: The dot plot provides valuable insights into the collective outlook of the FOMC on future interest rate policy. It indicates whether the FOMC expects to raise, lower, or maintain the federal funds rate to achieve its economic goals of price stability and maximum employment. Investors and businesses closely watch the dot plot to gauge the Fed’s monetary policy stance and make informed decisions about investments and economic strategies.
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Limitations of the dot plot: The dots represent individual forecasts, not a single, unified prediction. There can be some spread in the projected rates across members. The dot plot reflects the FOMC’s current thinking based on available information. Economic conditions can change, and the Fed might adjust its projections as needed.
How Fed Rate Decisions Impact Bond ETFs
Federal Reserve decisions, particularly regarding the target federal funds rate, will influence bond ETFs depending on factors including the direction of rates and the bond funds’ holdings.
Here’s a breakdown of the relationship between Fed policy and bond ETFs:
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Rates and bond prices: When the Fed changes the target federal funds rate, it generally leads to changes in interest rates across the bond market. This can cause the prices of the bonds within the ETF to rise or fall, depending on the rate decision.
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Inverse relationship: Interest rates and bond prices have an inverse relationship. For example, when interest rates fall, the value of existing bonds with higher fixed interest rates become more attractive compared to new bonds offering lower yields. This drives up the prices of existing bonds in the ETF. The opposite is true when interest rates are rising, was the case in 2022 and 2023.
Types of Bond ETFs and Interest Rate Impact
The impact of Fed rate decisions can vary depending on the type of bonds held by the ETF:
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Maturity of holdings: ETFs holding bonds closer to maturity might experience a less severe price decline compared to those with longer maturities.
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Short-term bond ETFs: These are generally less sensitive to interest rate changes because they mature in 1-3 years and their reinvestment rates can adjust to the new environment.
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Long-term bond ETFs: These are more susceptible to interest rate fluctuations as their fixed interest rates become less attractive when new, higher-yielding bonds are issued.
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Credit quality: Bond ETFs might invest in bonds with varying credit ratings. Bonds with lower credit quality (high-yield or “junk” bonds) can be more volatile in response to interest rate changes.
Outlook for Interest Rates and Bonds in 2024
Although the FOMC’s December 2023 dot plot forecast three 25-basis point cuts for 2024, widely watched inflation measures, such as the Consumer Price Index (CPI) and the Personal Consumption Expenditures Price Index (PCI), have remained slightly elevated at 3.2% and 2.8%, respectively, in reports released in February.
As of March 19, the Fed Funds Futures placed a 60% probability of the Fed’s first 2024 rate cut to come in June.
Investors will no doubt be watching for signs of disinflation, as well as language in the FOMC minutes, to support reasoning for the Fed to begin cutting rates later this year. However, if economic data remains inflationary, rate cuts would be pushed to later in the year, potentially causing bond yields to rise and prices to fall.