Why the hawkish Fed caused the debt market to move

Phalguni Soni

Must-know: US Treasury markets in the week ending August 22 (Part 3 of 9)

(Continued from Part 2)

Debt market moves while dealing with the hawkish Fed

The U.S. Federal Reserve decides economic monetary policy. The federal funds rate is its major tool. By moving this rate, the Fed controls economic interest rates.

Bond yields move in response to base rate changes. This impacts fixed-income exchange-traded funds (or ETFs). Fixed-income ETFs include the iShares iBoxx $ High Yield Corporate Bond ETF (HYG), the iShares iBoxx $ Investment Grade Corporate Bond Fund (LQD), and the Vanguard Total Bond Market ETF (BND).

The Fed has embarked on unprecedented monetary policy since the Great Recession. It’s kept the federal funds rate low since December 2008. It also embarked on three rounds of quantitative easing (or QE). QE involves purchasing bonds on the open market. Low rates and market liquidity stimulate business investment and create jobs.

Fed caught off-guard by the improving economy

At its last Federal Open Market Committee (or FOMC) meeting in July, the Fed discussed the improving economy. The rate of improvements in the economy and the labor market caught the Fed by surprise. The Fed also acknowledged that the risk of inflation persisting below target had “reduced somewhat.”

The Fed would normalize its monetary policy if its employment and job creation goals achieved targets earlier-than-expected. Normalization implies raising the federal funds rate and decreasing the size of the Fed’s bloated balance sheet.

The Fed’s balance sheet has increased to over $4 trillion from ~$900 billion pre-crisis. The increase is due to the Fed purchasing Treasury and mortgage-backed securities (or MBS). If the Fed reduced its Treasuries and MBS holdings, a considerable amount of liquidity would be erased from the market. As a result, interest rates would trend higher.

Higher yields reduce bond prices. Longer-dated debt would be affected more. It has higher interest rate sensitivity. However, rate increases benefit inverse exchange-traded funds (or ETFs) like the ProShares UltraShort 20+ Year Treasury (TBT). Floating rate debt ETFs also benefit because rates are indexed to market rates.

In the next part of the series, you’ll read about recent positive economic data that’s another major yield driver.

Continue to Part 4

Browse this series on Market Realist: