Considering Central Bank Influence on Yields
October 2015
Fed watching is a favorite pastime for many market
participants. Investors read statements from the US
Federal Reserve, or the Fed, as if they were tea leaves,
parsing new information and seeking to forecast future
Fed activity. The presumption is that Fed actions lead
to specific market outcomes. Recently, some market
prognosticators believed that the Fed was going to
begin raising the federal funds target rate. However,
what actually happened reinforced how difficult it
is to accurately forecast when a Fed tightening cycle
will occur or what its effects may be.
begin. However, history shows that short- and longterm rates do not move in lockstep. There have been
periods when the Fed aggressively lifted the fed
funds target rate—the short-term rate controlled
by the central bank—while longer-term rates did
not change or “stubbornly” declined.
A good example is the Fed’s last campaign of policy
tightening through the use of the fed funds target rate
(see Exhibit 1). From 2004 to 2006, the Fed increased
the rate by 4.25%, yet longer-term rates experienced a
period of decline. Alan Greenspan, Fed chairman at the
time, referred to this phenomenon as a “conundrum.”
The presumption of many is that longer-term
interest rates will rise when a tightening policy does
Exhibit 1: Fed Funds Rate and Treasury Yields
6
5-Year US Treasury
10-Year US Treasury
Fed Funds Target
Yield %
5
4
3
2
1
0
06/25
08/25
10/25
2003
12/25
02/25
04/25
06/25
08/25
10/25
12/25
02/25
04/25
2004
Past performance is no guarantee of future results. Source: Federal Reserve Bank of St. Louis.
06/25
08/25
2005
10/25
12/25
02/25
04/25
06/25
08/25
2006
10/25
12/25
DIMENSIONAL FUND ADVISORS
2
Exhibit 2: Late 1980s Inverted Yield Curve
10
5-Year US Treasury
10-Year US Treasury
Fed Funds Target
Yield %
9
8
7
6
5
03/30 04/30 05/31 06/30 07/31 08/31 09/30 10/31 11/30 12/31 01/30 02/28 03/31 04/30 05/31 06/30 07/31 08/31 09/30 10/31 11/30 12/31 01/31 02/28 03/31 04/30 05/31 06/30
1988
1989
1990
Past performance is no guarantee of future results. Source: Federal Reserve Bank of St. Louis.
Other periods of short- and longer-term rates moving
independently include the 1980s, when the fed funds
target rate was increased by more than 3% while longerterm rates remained largely unchanged. In fact, the late
1980s was a period marked by an inverted yield curve;
long‑term rates yielded less than short-term rates. This
can be seen in Exhibit 2: The green line representing the
fed funds target rate yielded more than 5- and 10-Year US
Treasury notes. There have been a number of instances of
inverted yield curves throughout history in the US (and
other developed markets).
and US Treasury securities.1 The news of the FOMC’s
scaling back of purchases in the open market resulted
in what became known as the “taper tantrum.”
Market forecasters speculated that the scaling back of bond
purchases by the FOMC would inevitably result in higher
interest rates. But interest rates actually declined when
the FOMC eliminated its purchases from January 2014
to October 2014.
Exhibit 3 illustrates yields on intermediate- and
long‑term US Treasury bonds from the time Bernanke
made his statement to Congress until the end of the
FOMC’s purchases in open market operations.
Another period when market participants attempted
to forecast specific outcomes based on Fed actions
occurred in 2013. In a statement to Congress on
May 22, 2013, Ben Bernanke, then chairman of the
Fed, asserted that the Federal Open Market Committee
(FOMC) was prepared to scale back its bond purchasing
program. At the time, the FOMC was purchasing
approximately $85 billion a month in mortgage-backed
As mentioned earlier, history shows that investors
who attempt to forecast interest rates have not
demonstrated any ability to consistently and reliably
predict the future path of those rates. Changes in fed
funds target rate, as well as short- and long-term rates,
Exhibit 3: Yields during Scaling Back of Bond Purchases
4.5
5-Year
10-Year
30-Year
4.0
Yield %
3.5
3.0
2.5
2.0
1.5
1.0
0.5
0.0
05/22
06/22
07/22
08/22
09/22
10/22
11/22
12/22
01/22
2013
Past performance is no guarantee of future results. Source: Barclays Bank PLC.
1. Statement from Federal Open Market Committee, September 13, 2012.
02/22
03/22
04/22
05/22
2014
06/22
07/22
08/22
09/22
10/22
DIMENSIONAL FUND ADVISORS
are not perfectly correlated—and are often driven by
market forces.
When analyzing the Fed’s impact on short-term rates,
we must also consider the unprecedented action taken
by the Fed since 2008—its massive issuance of reserves
paying rates of interest.
As Eugene Fama has noted in his research,2 the Fed
paid no interest to banks on excess reserves prior to 2008;
thus, there was an opportunity cost for banks depositing
excess reserves at the Fed. This opportunity cost naturally
encouraged banks to make loans and purchase securities;
the availability of loans and the money supply created by
banks purchasing securities creates downward pressure
on interest rates.
The Fed’s recent policy of paying interest rates on excess
reserves removed the previous opportunity cost, assuming
available rates in the market are not higher than what the
Fed is paying. Due to a lack of attractive spreads on loans
in the current market, holding excess reserves at the Fed
is now the more attractive option. Conventional wisdom
has been turned on its head.
3
By paying interest on excess reserves, the Fed has,
in essence, created new “short-term securities.” The
issuance of these reserves, or “short-term securities,”
pulls monetary supply out of the economy, which by
definition should raise interest rates. The question then
becomes: Has the Fed really been trying to keep interest
rates low? It does not seem that way. Perhaps, in an
effort to fight deflation, the Fed has actually been trying
to push interest rates higher, yet the lack of attractive
lending opportunities in the market has flooded banks
with deposits, pushing interest rates lower and limiting
the power of the Fed.
In his academic blog, Professor John Cochrane3 also
analyzes the effect of the Fed on interest rates. He poses an
interesting rhetorical question: “Is the Fed in fact ‘holding
down’ interest rates?” To answer this question, he points
out that the Fed, to keep interest rates low, will lend money
to banks at low interest rates so banks can then lend that
money to the rest of the economy, making a spread. But,
instead of going out to the market to find “higher” interest
rate opportunities, banks have deposited $3 trillion worth
of reserves at the central bank despite the “low” rates being
paid. If the banks find the Fed rates attractive, is the Fed
really keeping interest rates low—or high?
2. Fama, Eugene F., “Does the Fed Control Interest Rates?” working paper, University of Chicago Booth School of Business, 2013.
3. johnhcochrane.blogspot.com/2015/09/is-fed-pulling-or-pushing.html.
All expressions of opinion are subject to change. This article is distributed for informational purposes, and it is not to be construed
as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services.
October 5, 2015
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