What change at the Fed ultimately means for bond markets

Few events in the economic calendar attract as much scrutiny as central bank meetings. These meetings do more than announce the current level of interest rates. They also provide insight into how policymakers are interpreting the economy, and how they may respond as the outlook for growth and inflation evolves.

This process has gained increased attention this year with Kevin Warsh replacing Jerome Powell as Chair of US Federal Reserve (the Fed). Whilst Powell was an advocate of transparency in monetary policy, Warsh has taken a different approach, arguing that previous regimes placed too much weight on forward guidance, and has moved towards a more streamlined communications framework. 

Part of Warsh’s argument centres on a critique that detailed guidance can suppress price discovery, encourage excessive confidence in policy outcomes and reduce market discipline. The expectation is that by providing less guidance, markets are required to place greater weight on incoming economic data when assessing the outlook for interest rates. This type of approach isn’t without precedent. In his time as Fed chair, Alan Greenspan was known for communicating in a way that deliberately left room for interpretation, and once quipped “If I seem unduly clear to you, you must have misunderstood what I said.”[i] In an effort to overhaul how the Fed conducts monetary policy, Warsh has introduced five task forces, conducting sweeping reviews of communication, data inputs, the impact of technology on the economy, the framework around inflation and the use of the central bank’s balance sheet.

The changes have caused confusion, with sizeable swings in bond markets, as investor expectations for future interest rates shift materially from one meeting to the next. This raises the question, should bond investors brace for increased uncertainty and higher volatility under this new Fed regime?

[i] Comments made to Subcommittee of the US Congress, November–December 1987

In truth, the significance of central bank communications can be overstated. Whilst they are certainly market-moving over short-term horizons, too much focus on them risks succumbing to noise and missing broader trends. Ultimately, central banks set monetary policy in order to meet their mandates, which explicitly or otherwise seek to keep inflation well-anchored and help smooth economic cycles.

It’s therefore important to get the feedback loop the right way around. Yes, central bank policy has an impact on the real economy, but it acts with long and variable lags. It is first and foremost economic data that drives central bank policy, and should the incoming data change, the outlook for interest rates should follow.

A common way to think about this is by setting out a rule of thumb to describe central bank behaviour. The Taylor rule is a common tool for doing so: a combination of inflation and the degree of spare capacity in the economy can provide a useful guide for where policymakers will set interest rates. The experience through 2021 and 2022 show the limits of forward guidance. With inflation already beginning to rise coming into 2021, the Fed initially stuck to guidance that inflation pressures would prove transitory and instead continued with guidance that interest rates would remain lower for longer. As the scale of the inflation surge became clear, committee members were forced to repeatedly raise their projections and related guidance.

This episode highlights that, regardless of the degree of transparency, it is ultimately the data that will win out. Keeping this in mind is important for investors to look through the noise that often surrounds central bank meetings.

The debate surrounding Federal Reserve leadership has attracted considerable attention this year. Whilst Warsh’s appointment has added uncertainty, it is the economic data that is truly keeping policymakers and investors on their toes this year, continuing a trend of recent years.

At the start of the year inflation was expected to trend down to target and provide room for further interest rate cuts. Forecasts have been revised around 1 percentage point higher over the course of the year, whilst growth forecasts have been revised lower. The war in Iran has created fresh uncertainty around the macro outlook. Whilst momentum in AI development is driving debate about whether high rates of capital expenditure could support stronger economic activity and place upward pressure on inflation, or whether productivity improvements and automation will begin to push inflation lower. This shifting economic backdrop has led to significant changes in market expectations for policy rates.

These questions will take time to be resolved and are part of a wider shift in the economic backdrop that may mean bond markets remain more volatile than what was considered normal during the period preceding the Covid pandemic.

The return of inflation as a source of risk means that investors cannot rely solely on bonds to provide diversification in portfolios. Periods when equities and bonds move in the same direction, rather than offsetting each other, have increased in recent years. As a result, investors need to look beyond traditional stock-bond diversification and consider a broader range of asset classes to help build resilience across different economic environments.

Bonds remain an important component of a well-diversified portfolio. During periods of weaker growth and easing inflation, expectations for lower interest rates can support bond returns at a time when many economically sensitive assets are struggling.  

In addition, as starting yields tend to be a good guide to future long-term returns, today’s yield levels suggest bonds can once again offer a meaningful source of income and portfolio returns, compared with the low-yield environment that characterised much of the pre-pandemic era.

What does this mean for portfolios? The change of leadership at the Fed has created some additional headline noise this year, but investors should remain focused on the fundamentals. Many of the drivers of uncertainty in the economic outlook today cannot be controlled by monetary policy, and more transparent communication by the Fed likely wouldn’t change that. A volatile data environment demands patience and focus on portfolio construction not central bank rhetoric. The key is to be clear about the role bonds play in portfolios, which environments they will be sensitive to, and whether the starting yields they offer are attractive to investors holding them given prevailing economic conditions.

This content has been prepared by the Life Investment Office (LIO) for information purposes only and does not contain or constitute investment advice.