A New Age of Policy Transparency
The Federal Reserve, beginning in 2011, began a new era of transparency that began with the publishing of economic and monetary policy projections from Open Market Committee members. Along with projections for unemployment and GDP, they now include two critical charts: Appropriate timing of policy firming and Target federal funds rate.
The Treasury curve itself represents the expectation of the Federal Funds path, plus whatever extra term premium investors may demand for holding longer dated securities. We calculate the expectation – the forward rate – by using the difference in rates at two maturities to find the expected return after investing in the shorter maturity and imputing the yield it would take to break even with the yield of simply buying the longer maturity.
As of January 2012, the Federal Reserve explicitly set a 2% inflation target. This combines with the consensus of the committee’s longer-run target Fed Funds rate of 4% — 2% nominal, 2% real. While this had been assumed for a long time, despite the implementation of two quantitative easing programmes, the term premium embedded in the forwards relative to this expectation actually didn’t consistently break negative until it was announced.
Michael Woodford’s 2012 Jackson Hole paper and speech, Methods of Policy Accommodation at the Interest Rate Lower Bound, furthered the view that projection of expectations has the most impact on assets of any monetary policy tool. The evidence post-new-Fed-era-disclosure is consistent with that conclusion.
The impact of Federal Reserve policy really is broken down into three classes: markets which the Federal Reserve is directly targeting, those that they are trading, and in those which the Fed is doing neither.
The overnight rate is under the Federal Reserve’s direct control, facilitated by the unique tools afforded to a central bank. After January 2012, combining the Fed’s existing dominance over overnight rate with the Treasury curve being the sum of Fed Funds path expectations, the Treasury curve could also be considered directly targeted, albeit with the optionality of policy deviation potentially presenting a positive or negative term premium.
The agency mortgage market falls under the traded market class. Instead of price targets, the Fed has set macro conditional purchase volume targets. This serves to increase liquidity and decrease asset supply of the traded market. The impact of the Fed’s policy on these markets can be inconsistent, however: if the Fed is simultaneously buying and conveying uncertainty about continuation of future policy, the market will react by forming an equilibrium to the average expectation of both the normal supply and demand of the asset, combined with the extra projected demand from the Fed.
Markets of all classes which the Fed does not either target or trade are still impacted by the actions the Fed takes in the markets which they do. Much like traded markets class, the minimum return demanded by investors must be at least that of the equivalently termed risk-free investment. More broadly, investors demand the minimum return on any asset to be greater than the equivalently termed lesser perceived risky investment.
The expected return of any asset is the weighted-average outcome of probabilities (summing 1) multiplied by their respective scenario returns.
E(R) = ∑ (probability₁ * return₁) + (probability₂ * return₂) + (probabilityⁿ * returnⁿ)
Unless market participants are willing to accept a lower probability-weighted expected return, the expected return across all assets in this class of market is the same after beta and liquidity premia.
The penultimate question remains: what will happen to asset prices when policy begins to normalise?
The Equity Market
The mean monthly total return of the S&P 500 is 0.65%. That return drops, but is still positive when the Fed Funds rate increases, to 0.45%. However, when the term premium between the 10y and Fed Funds rate is positive, the average return returns to 0.64%. When the term premium is above 1%, the average return is even higher than the sample mean – 0.82%! When adding the condition that the benchmark rate falls, the mean monthly return climbs to 1.27%. This tells us something very significant to the discussion: the price of S&P 500 contains the expectation of monetary policy. Thusly, monetary policy tightening has not negatively impacted the S&P 500 unless it happens more quickly than the market expects. In fact, both the 10y and the equity market don’t necessarily negatively react to Fed Funds hikes.
Consider the simple equation:
EY = ERP + 10y
ERP = EY – 10y
The Equity Risk Premium, or ERP, contains the information on the spread of expectations between our benchmark asset (the 10y) and the equity market. If the stock market assumed no growth, but the certainty of return on capital was 100%, the difference between the benchmark rate and the stock market would be minimal. In reality, the expected difference in returns diverge with expected inflation, liquidity needs, and the expected future rate path.
The term structure, as represented by the 2s10s Treasury term spread, has contributed from 2.43% to -1.83% to ERP.
Let’s fill in a little more detail into the ERP equation:
ERP = (Real 10s * -0.58047) + (SPX 1y RV * 8.83836) + (2s10s * 0.85830) + (Residual Risk Premium)
A few observations: the most volatile term is the liquidity contribution, which we estimate as the sum of the SPX 1y Realised Volatility and residual error (viewed as the Residual Risk Premium). However, it is also the most mean-reverting. The fundamental premise is that this is the true equity market risk premium, and although unknowable, will either compress, or ultimately be shifted to the other terms (real rates and the 10y). The Real 10y represents inflation expectations, and therefore the fulcrum on which the preference for fixed cash-flows rests. The last two pieces of the equation, the term structure and 10y, represent the minimum required return, and the embedded expectations for how the discount rate will move in the future.
Using this framework, we can run some thought experiments on potential future interest rate scenarios.
The simplest scenario would be estimating a full policy normalisation – a Fed Funds rate at 4% (2% real, 2% nominal) as estimated by the FOMC for the long-term rate, and a 5% 10y (1% term premium). In this scenario, the 2y is unlikely to be less than 4.5%, leaving a 2s10s spread of 0.5%, which is consistent with a post-policy normalisation mid-economic cycle value. At first blush, since EY = ERP + 10y, the 10y portion of the EY equation is increased by 217bps. However, simultaneously, the 2s10s term in EY likely declines by 186bps (216.5 * 0.85830). Therefore, if neither inflation expectations or the liquidity premium change, EY would increase around 31bps – roughly 80 S&P 500 points lower than at the time of writing (4.8% of 1,665) if there were no change in EPS. In the context of the discussion, this is a rounding error.
It is not necessarily the case that the other two terms, liquidity premium and inflation expectations, remain unchanged during this process. Monetary policy normalisation would likely push real rates higher, which would be on balance positive for equities (recall that the real rate term has a coefficient of -0.58, which means real rates rising compresses ERP, which would increase the value of stocks if the benchmark rate & earnings were unchanged). The last term, the liquidity premium, is the most difficult to forecast, but also the most quickly normalising. It is likely unknowable where this will be on a day-to-day or month-to-month basis, but of all of the terms, it is the least stationary.
Monetary policy normalisation does not seem likely to adversely impact equities as long as it is occurs no more quickly than the market has already priced in.
The Corporate Bond Market
The bond market is, perhaps, more straightforward. While the impact of the term structure must be teased out with techniques like component analysis and decomposition, the rates market has a term structure that directly conveys expected future rates.
Long-term rates are reasonably well anchored. What happens in the intermediate-term is far more volatile, however, and the impact of intermediate-term expectations adds to the volatility to the long-term bonds because of the no-arbitrage condition embedded in the forward rates.
The Baa spread between both 10s and 20s have enjoyed a very close relationship over many decades. As the expectation of ZIRP’s eventual end begins to ripple through the curve, the spread has blown out, and the Baa-10s has not normalised to previous post-recession levels, ostensibly because of the abnormally low short-rates this far in the economic cycle.
The expectation of higher (lower) future rates correlates with compressing (widening) future credit spreads. After all, why take on credit-risk now when you expect you can purchase risk-free securities at competitive rates later?
Questioning the Veracity of the Term Structure
A termed risk-free rate in the future is the Net Present Value of the risk-free rates to maturity. This is an opportunity-cost or no-arbitrage condition: for instance, no-one will purchase a 10y now with the expectation purchasing a 7y to rolled into a 3y, or or that time-weighted average of overnight rates, will make more money.
The average FF-NGDP value in expansion -2.19%. The same value in recession is 4.26%.
The consequence is that those predicting a policy normalisation are actually either implicitly forecasting an acceleration of NGDP to somewhere near 6%, or that the Fed will tighten prematurely (which would likely lead to recession).
Since 1Q 2012, NGDP %-y/y has declined every quarter but once, and as of the time of writing, is just 2.9% – the lowest ever outside of, or leading into, recession. The policy neutral position as priced into the curve already assumes a level of acceleration or policy error that seems unlikely at this juncture.
If the expectations for Fed hiking soften, the benchmark rate could simultaneously soften with a flatter term structure. Ceteris paribus, both would contribute to lower rates, credit spreads and earning yields.
Markets are not impacted by monetary policy normalistion so much as the shifting expectation of normalisation.
Not only is policy normalisation expected to have a minimal impact on asset prices moving forward, but the probabilities of a slower normalisation appear underpriced.