Telling the Future – The Federal ReserveAuthor: John MasonLast Updated: March 20, 2014 Expectations play such an important part in the bond markets. Yesterday is an example.The Federal Reserve releases a set of economic forecasts indicating what Fed officials believe the future might turn out to be. Financial markets were struck by one part of these forecasts, the part that has to do with the benchmark Federal Funds rate. In the release coming out yesterday, the report indicated that Fed officials had raised their expectations for the Federal Funds rate at the end of 2015. They now expected the rate to be 1.00 percent, up from a previously expected 0.75 percent.Investors jumped on this change!The yield on the 2-year Treasury note jumped from 0.48 percent, where it closed on Tuesday evening, to 0.57 percent at the close of business on Wednesday.The yield on the 10-year Treasury moved from a 2.67 percent close on Tuesday to 2.77 percent on Wednesday.These are pretty substantial one-day moves. And, Treasury yields have risen further today.An interesting aside is that the yield on the 10-year Treasury Inflation Protected security from 0.48 percent to 0.57 percent leaving the inflationary expectations built into the bond market roughly constant at 2.20 percent.Expectations are so important in the bond markets and you will generally see the biggest moves in the market when something happens that was not expected.In this instance, Federal Reserve officials did not really seem to believe that this little difference was that much to worry about and Janet Yellen, Chairwoman of the Board of Governors of the Federal Reserve System seemed somewhat surprised at the fuss that was made over this change.Yet, the change “broke” expectations. Investors had been expecting the interest rate to be 75 basis points at the end of 2015 and here the Fed was now saying that they expected the rate to be one-third higher than before at that end-date.Once the word got out that there was a change in what the Fed believed the interest rate would be, the market adjusted quickly. Interest rates rose.Now, let me just bring up an important point here. The Federal Reserve through its “forward guidance” indicated that officials believed the Federal Funds rate would be 1.00 percent. The market had a specific number for the future.A problem can arise if market participants do not have such specific “forward guidance” and have to “guess” at what the future market interest rate will be.This often happens in a liquidity crisis. Let’s assume, to present an example that the Federal Reserve had been working with a target range for the Federal Funds rate of 3.50 percent to 4.00 percent. Now suppose, the Federal Reserve wants interest rates to rise but it allows market conditions, an increase in the demand for funds, to cause the Federal Funds rate to rise above 4.00 percent.In this case, expectations have been broken because the market expected the Fed to intervene when the Fed Funds rate hit 4.00…but it didn’t.So expectations have been broken…but, the market wonders, what is going to be the new range for the Federal Funds rate? No one knows…and the Federal Reserve has no let on what the new range is going to be.In situations like this, the buy side of the market will often sit on the sidelines for a while…or, as I have contended in the past, they will go play a round of golf. The buy side will go away because they don’t want to get buying bonds when interest rates might be going higher. They do not want to purchase bonds until they get an firm idea of where the market is going to stabilize…because they would be risking capital loses as bond prices continued to fall.This is just an example of how the market performs in periods where expectations are broken. In the current case, expectations have been broken and the market has responded. But, the market has responded in a constrained way since the Fed has given the market some “guidance” as to where it believes interest rates will be in the future.The lesson? In my experience, the financial markets…and specifically the money markets and the bond markets…have layer over layer of expectations about the future. In the past, this layering of expectations can go from what might happen in the next hour to what might happen in the next four hours…eight hours…two days…the next week…the next month…and so on and so forth.With “forward guidance” some of this layering has gone away…and this, potentially, makes for the possibility that the volatility of these markets might become greater.This past five years or so has been a special time…not like any other. The Federal Reserve has supplied the banking system with massive amounts of reserves, most of which are just lying around…not being used. Loan demand on the banking system has been next to non-existent. There have been little or no pressures on short-term interest rates. Consequently, short-term interest rates have remained very, very low.The issue now is that the Federal Reserve is hoping that the banking markets become a little more “normal”, that loan demand picks up, and the economy starts to grow a little more rapidly.In such an environment, Federal Reserve officials will have a much more difficult time predicting what the level of interest rates will be. And, if we return to more “normal” conditions, my bet is that the Federal Reserve, being made up of humans, will find it a great deal more difficult to forecast interest rates…let alone give investors “forward guidance.” How much confidence do you have that the Federal Funds rate will be 1.00 percent in twenty-one months?The fact is that the Yellen-Fed seems to be moving away from “forward guidance” already.Still, investors will build up expectations about what interest rates will do in the future and they will build their market portfolios based upon these expectations. What these investors expect the Fed to do will play a role in determining what these market expectations are. And, the breaking of these expectations will have dramatic impacts on the bond and money markets.This is something investors and traders in these markets are going to have to put back into their asset allocation efforts. The last five years have been highly unusual…who would have thought that the Federal Reserve would have been able to predict the level of the Federal Funds rate out for two or three years? I certainly would not have thought that it could. But, now we are going to return to another world…a world where interest rates will not be so predictable. This is just something that all participants in the bond and money markets are going to have to accommodate.About John MasonJohn MasonJohn has been the President and CEO of two publicly traded financial institutions and an Executive Vice President and CFO of a third. He has also spent time as an economist in the Federal Reserve System and worked for a cabinet secretary in Washington, D. C. In addition John taught in the Finance Department at the Wharton School of the University of Pennsylvania for ten years. He now currently has a column on the blog Seeking Alpha and is ranked number 3 in terms of readers on the economy. From this column, two books have been published this past year from earlier blog posts. John is active in the shadow banking world, the venture capital space, and in angel investing. Other than that John works with start ups and early stage organizations, for profit and not-for-profit.