Bond Trading 102: Fed Watching
Forecasting just about anything, be it weather, corporate earnings, or financial markets, forecasting changes in interest rates is as much an art as a science. It is impossible to forecast with extreme accuracy, but professional bond traders employ various techniques to try to stack the odds in their favor. Because the Fed changes interest rates to implement monetary policy in order to pursue its stated goal of “price stability and sustainable economic growth,” predicting what the Fed is going to do can help forecast interest rates. “Fed watching” is something that virtually all bond traders do to help them determine the future course of interest rates.
Fortunately, the Fed goes to great lengths to avoid disrupting the financial markets with surprise policy changes, so they are very transparent regarding their policy intentions. The first important principal to keep in mind is that the Fed does not like to change policy if it doesn’t have to. The Fed will typically maintain their current policy unless there is a compelling reason to change. Keeping track of important economic indicators such as GDP, which measures economic growth, and CPI, which measures inflation, can provide a leading indicator of changes in Fed monetary policy. A significant slowing of growth of GDP, or a decline, could indicate that the Fed may ease monetary policy, especially if CPI indicates low inflation. Extreme growth in GDP and/or a significant increase in CPI could indicate a change to a more restrictive monetary policy. However, the Fed is not likely to change policy quickly, and is not likely to react immediately to these indicators, but will most likely follow them for a few months to see if a definite trend is developing.
The Fed directly impacts short-term rates by targeting a level of the federal funds rate, and since 1994 the Fed has publicly announced this target. It is important to note that the Fed directly influences short term rates, but longer term rates are less directly affected. The further out the yield curve one goes, the less of a direct impact the Fed’s target has on interest rates.
The Fed is very communicative and transparent about its thinking The Fed issues frequent press releases and policy meetings are announced well in advance, and the minutes of these meetings are subsequently released to the public. In addition, Fed officials make frequent speeches and often testify before Congress. Needless to say, bond traders scrutinize each Fed communication very carefully. Each Federal Open Market Committee (FOMC) meeting is followed by a statement that details the specific target range for fed funds, as well as their thoughts on the state of the economy. These statements give an indication whether Fed policy is easy, neutral or tight. They also often contain hints as to whether the Fed is leaning towards a change in policy.
Here is the FOMC policy statement from January 30, 2008:
The Federal Open Market Committee decided today to lower its target for the federal funds rate 50 basis points to 3 percent.
Financial markets remain under considerable stress, and credit has tightened further for some businesses and households. Moreover, recent information indicates a deepening of the housing contraction as well as some softening in labor markets.
The Committee expects inflation to moderate in coming quarters, but it will be necessary to continue to monitor inflation developments carefully.
Today’s policy action, combined with those taken earlier, should help to promote moderate growth over time and to mitigate the risks to economic activity. However, downside risks to growth remain. The Committee will continue to assess the effects of financial and other developments on economic prospects and will act in a timely manner as needed to address those risks.
Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Donald L. Kohn; Randall S. Kroszner; Frederic S. Mishkin; Sandra Pianalto; Charles I. Plosser; Gary H. Stern; and Kevin M. Warsh. Voting against was Richard W. Fisher, who preferred no change in the target for the federal funds rate at this meeting.
In a related action, the Board of Governors unanimously approved a 50-basis-point decrease in the discount rate to 3-1/2 percent. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of Boston, New York, Philadelphia, Cleveland, Atlanta, Chicago, St. Louis, Kansas City, and San Francisco.
Notice how the FOMC states that they are reducing the fed funds rate by 50 basis points. Also, the statement “However, downside risks to growth remain. The Committee will continue to assess the effects of financial and other developments on economic prospects and will act in a timely manner as needed to address those risks.” This would indicate the fed is concerned about whether growth will continue and indicates that there could be additional cuts in the future. Since falling interest rates mean rising bond prices, this statement could present a buying opportunity (as subsequent rate cuts proved to be the case). The best time to act is when the Fed changes policy (for example, from neutral or tight to easy).
One may think that once the policy statement is released, it is too late to act on the news, but history has shown that market rates continue to change for a period of time after a policy change. There are several reasons for this. First, rate changes tend to move in trends. Second, the Fed does not like to make large changes to the fed funds rate, as this may lead to too large a change in the other direction. For example, if inflation is high and the Fed wants to raise rates to cool off the economy, a large change in interest rates may send the economy into a recession. The Fed will usually make a small change, typically 50 basis points, but sometimes as small as 25 basis points. They will then wait to see how the economy reacts, and make another small change if they need to. It usually takes a number of rate changes before the economy reacts. Because of this, there are most often a number of rate changes in the same direction as the Fed pursues its monetary policy. The chart below, which tracks changes to the fed funds target rate for the last twenty years, illustrates the point. 
Press releases, public speeches, and congressional testimony can also reveal what the Fed is thinking about the economy and their policy bias. Though not as straightforward and easy to interpret as policy statements, they can be quite helpful in foreshadowing upcoming policy meetings.
Treasuries are the securities that are most often traded based on Fed policy, as they are the most pure interest rate play since they have no credit risk. The decision for the trader than becomes which treasury. Most professional traders choose the 2-year to trade based on changes to the fed funds rate. As we have stated previously, the shorter the maturity of the security, the more closely it tracks the feds funds rate (this should be obvious). We know that the longer the maturity of the bond, the more price sensitive it is to changes in interest rates, so you might think that longer maturity bonds would be the security of choice for trading changes in interest rates, but they are much less influenced by changes in the fed funds rate. The 2-year is a good compromise between the correlation to the feds fund rate and price sensitivity. As the chart below illustrates, the 2-year follows the feds fund rate fairly closely, while the 10-year and 30- year are much less correlated. The Fed is the primary driver of short-term rates, but expected inflation rates are the primary driver of long-term rates. 
Note, however that there are times when the 2-year does not closely track fed funds, look at the period from the end of 2001 through the first half of 2002. This indicates that trading the 2-year based on fed funds can be risky.
When monitoring the Fed in order to forecast interest rates, it is important to also keep an eye on important economic indicators that measure economic growth (like GDP), inflation (like PPI and CPI), and employment (like the unemployment rate and average initial weekly claims for unemployment insurance), to ensure that your interpretation of what the Fed is saying is consistent with the data that the Fed is using to help set monetary policy.
Economists and researchers have developed very complicated mathematical models to forecast interest rates. Unfortunately, these have not proven to be particularly accurate and most of them have not proven any more valuable than a random walk in forecasting rates, so their usefulness to bond traders are questionable, and we will not go into them here.
