We are asked from time to time when the Fed will start to raise the funds rate. Our basic answer is that this will happen on the first meeting after 3-month TBill yields move above the upper band of the current 0% to .25% funds rate target. Given that TBill yields ended last week at .125% perhaps another answer would be… not any time soon.
We find all kinds of ways to get ourselves in trouble with respect to the markets but at the top of the list of major ‘no nos’ would be arguing with the bond market. Quite often the bond market will start trending in a direction that seemingly makes no sense but it is almost always a good idea to accept what the bond market is ‘saying’ and trade accordingly.
We started off today with a comment about the Fed funds rate and then did a hard right turn over to the bond market. Now we are going to attempt to explain where we are going with all of this.
Below is a comparison between 3-month TBill yields and 30-year Treasury yields from 1999 into 2001.
Further below we feature the same comparison from 2003- 04.
The argument is that the Fed most certainly does not ‘lead’ the market. The market, in fact, leads the Fed.
In January of 2000 30-year TBond yields reached a peak. A full year later the Fed finally cut the funds rate. The bond market had been telling anyone who would listen that growth was slowing months ahead of the peak for the Nasdaq, a few quarters before copper and crude oil futures prices reached a top, and almost exactly one year before the Fed recognized that it was time to start to ease credit.
In June of 2003 30-year TBond yields reached a bottom. The Fed finally increased the funds rate for the first time following the Nasdaq’s 2000 collapse in June of 2004- one year after 30-year yields turned upwards.
In both instances a month or two before the Fed changed its policy stance the trend for long-term Treasuries worked through the bond market until 3-month TBill yields began to follow. At the next meeting the Fed changed the funds rate.
Equity/Bond Markets
Above we argued that long-term Treasury yields began to decline a full year before the Fed shifted policy in response while in 2003 yields rose for one full year before the Fed made its initial rate hike.
Belowis a comparison between the Bank Index (BKX) and 10-year Japanese (JGB) bond futures from 2006 into 2008.
If the bond market heads in one direction for a year or more until the Fed finally finds enough reasons to change the funds rate then something must have happened in the interim to make it so. In other words in 2000 the bond market was correct in forecasting a problem for capital spending and in 2003 it responded perfectly to the stresses of rising energy prices.
So… what did the bond market have to ‘say’ about 2008’s subprime crisis?
The problem may have hit the proverbial wall in 2008 but it began in earnest back in 2007.
The next chart shows that Japanese 10-year bond futures prices bottomed at the end of the second quarter in 2006. Based on the one year lag it was possible that growth would start to slow some time around the middle of 2007. At the end of the August FOMC meeting the Fed decided to hold the funds rate flat at 5.25%. A few days later on August 10th the Fed issued a statement saying that it was ‘providing liquidity to facilitate the orderly functioning of the financial markets’. On August 17th the Fed stated that ‘financial market have deteriorated’ and that ‘the downside risks to growth have increased appreciably’.
At the conclusion of the September 18, 2007 meeting the FOMC cut the funds rate from 5.25% to 4.75%.
We grant that the sell off in long-term bond prices into June of 2007 helped obscure the rising trend that began back in 2006 yet… once again the long end of the bond market ‘led’ the Fed by close to a year. In hindsight the Fed should have been actively cutting the funds rate in August of 2007 instead of simply issuing statements.
After all of this we finally get to our point. We hope.
At bottom is a comparison between 3-month TBill yields and 30-year Treasury yields from the current time period.
The premises are that one year AFTER long-term bond yields make a key top or bottom it may be time for the Fed to adjust policy especially if 3-month TBill yields start to drive in the same direction as long-term yields.
In theory the low point for yields following the post-crisis time frame was October of 2009 while the high point was reached in April. IF yields were to hold the lows made last autumn as we move through the end of the next quarter and IF TBill yields were to rise above .25% THEN a case can be made that the funds rate will start to rise as early as the fourth quarter of this year. For that to happen, however, the bank stocks will have to return to outperforming the broad market.
