EDHEC-Risk Institute’s professor of finance, Riccardo Rebonato, says there are a few reasons why the latest March projections for the Fed Funds in the year to come, made by the Fed Monetary Committee, were lower than the expectations from December.
Rebonato, who is a specialist in interest rate risk modelling with applications to bond portfolio management and fixed-income derivatives pricing, said that market yields reflected expectations but also incorporated a risk premium, which was a compensation for bearing risk.
“This is generally thought to be positive (say, for equities), but in the case of Treasury bonds the picture is more nuanced: to the extent that investors have come to believe that the Fed will always come to the rescue to mop up the debris of any severe market turmoil (the Greenspan/Bernanke/Yellen and now perhaps Powell ‘put’), Treasuries have become insurance instruments,” he stated.
Another explanation might be that in the present environment, deviations from the most likely outcome were likely to be placed very asymmetrically, with more negative than positive surprises in the wings.
Additionally, President Trump adopted a more more interventionist policy with the Fed than any of his predecessors in recent memory and investors may just think that betting against the Fed is, in the end, less risky than betting against Trump.
Also, according to Rebonato, even though the expectations against what the Fed said might seem like a daring bet, after all, it was the Fed that set the course of Fed Funds rate.
“Which one is true? Nobody knows, of course,” Rebonato said.
“The most striking observation is how much the expected path of the Fed Funds has flattened in the last few years – see the chart below; if anything the market yield curve even shows a small inversion.
“And a flat or inverted yield curve has traditionally been associated with low or negative risk premia, with challenging times for bond investors, and for sluggish economic growth,” he said.