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Connecting the Dots on the Recent Bond Market Price Action

Connecting the Dots on the Recent Bond Market Price Action

June 22, 2021
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The “dot plots” are slowly becoming the new phrase of the year after the July 16 Federal Reserve (Fed) meeting. As a reminder, the dot plots represent the expected path of short-term interest rates by Fed members. Each dot represents a member’s opinion on where the Fed funds policy rate should be over the next few years. While not official policy, it does provide additional transparency into Fed member thinking—albeit anonymously. Along those lines, St. Louis Fed President Jim Bullard made headlines by saying he was one of the Fed members who now thinks raising short-term interest rates in 2022 makes sense. His comments were notable as he has generally been seen as reliably dovish and has argued for more accommodative monetary policy in the past. (For more on what doves and hawks have to do with monetary policy, please see the June 21 Weekly Market Commentary.) Markets, always on the lookout for hints on Fed policy, have interpreted the recent dot plot release and Bullard’s comments as a hawkish shift in policy. Consequently, fixed income and equity markets reacted sharply to the news.

“Markets are looking for any sign of a change in Fed policy,” noted LPL Financial Fixed Income Strategist Lawrence Gillum. “Unfortunately, some of the ways in which the Fed is communicating are actually adding confusion and volatility to markets. We think it’s important for investors to filter out this noise and concentrate on longer-term goals.”

As seen in the LPL Research Chart of the Day, the bond market’s reaction can be seen as a tale of two interpretations. The front end of the yield curve sold off (yields increase as prices decrease), which is consistent with the prospect of earlier rate hikes. Short-term Treasury yields are more sensitive to changes in monetary policy, so higher yields for two and three-year tenors are consistent with the Fed’s expectation for raising policy rates in the next few years. However, the big rally in bonds on the longer end of the yield curve is more consistent with slowing growth expectations—something we tend to see during an actual rate hike campaign.

We think the move higher in yields on the front end of the curve is likely the right interpretation of shifting Fed policy, whereas we don’t think investors should read too much into the price action on the long end of the curve. We don’t think the bond market is pricing in a much slower growth environment. The exaggerated move in longer-term yields was likely from a popular trade on higher long-term Treasury yields unwinding into a Treasury market with more sellers than buyers. A number of liquidity indexes we watch support that view. So, the lack of liquidity in the bond market last week helped push longer-term yields lower—more so than a shift in Fed policy would suggest.

View enlarged chart.

When the dot plot was originally released, it was intended to provide additional transparency into the way individual members were thinking about monetary policy. In fact, these dot plots have often added confusion and volatility to markets, yet another reason the Fed tries to downplay the importance of these releases. In fact, during last week’s post-Fed meeting press conference, Chairman Powell said the dot plots should be taken with a “big grain of salt.” We agree. So, hopefully, we can stop talking about dot plots soon. Well, at least until a new set of dot plots are released after the Fed’s September policy meeting.

 

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