The Secular Decline in Long-Term Yields around FOMC Meetings

Posted on May 8, 2021 by Florian Buschek

is a fascinating paper from March 2020 from Sebastian Hillenbrand. Some amazing figures and results follow.

Long-term U.S. Treasury yields fell by almost 8% between 1980 and 2017. I document that
the entire decline in long-term interest rates was realized in a 3-day window around FOMC
meetings. I find a similar pattern for U.S. equities: the same 3-day window can account for
the entire decline in equity yields over the same time period. Decomposing the decline into
an expected short-rate and a risk premium component, I find that the fall in long-term yields
around FOMC meetings can be mostly attributed to a lower expected path for future short
rates. I argue that these results are surprising in light of theories on monetary policy and the
secular decline in interest rates.

This chart clearly shows how the 10yr yield changes almost all happened around FOMC meetings.
While TIPS yields declined along along with nominals almost non if it was inflation expectations, which themselves mostly adapted outside FOMC windows.
Even equity valuations mostly adjusted around FOMC meetings.
“This figure compares the cumulative log excess returns of various investment strategies. The “FOMC strategy” invests
into the 10-year Treasury security (or equities) during the 3-day window and invests into the risk-free bond on other days.” Since the FOMC strategy misses the valuation change during that window the performance is terrible.

These are quite amazing results. One view is that interest rates declined over the years because of factors like demographics, technological advancement, globalization etc. Looking at these charts it seems like interest rates were purely driven by the FOMC however. My theory is that both views are correct to some degree although I would give more weight to the former with the addendum that the market is waiting for Fed signals to actually reprice. In other words the natural tendency has been for yields to go lower but nobody wants to “fight the Fed” in case the Fed was going to tighten. So if on FOMC day the Fed does not signal rising rates or generally a hawkish stance then the external forces can do their work and the market adjusts. Admittedly this cannot be directly concluded (or refuted) from this research since the FOMC window defined here includes the day prior to the meeting. It certainly would be interesting to see what happens if the day prior is excluded. But then again it cannot also be said that only the Fed determines long term rates since how would the market know and price in what the Fed says the next day.

That equities reprice to such a large degree in the same time window is a bit surprising. True they follow risk free rates down and if those decline in certain time windows, valuations should adjust in that same window. But short term the relationship between valuations and risk free rates is often erratic due to changing equity risk premia. Looking at the last figure this is somewhat reflected in the differences between the equity and treasury strategies. The FOMC equity strategy underperforms vastly more to the conventional equity strategy than the FOMC treasury strategy underperforms the conventional treasury strategy.

I’ll end this post with the author’s conclusion

This paper documents that the entire secular decline from 1980 to 2017 in long-term U.S. Treasury yields
and two measures of the equity yields, the dividend yield and the smoothed earnings yield, was realized
in the 3 days around FOMC meetings. For every scheduled and unscheduled meeting since 1980, this 3-
day window includes the day when the market learned about monetary policy decisions, as well as the
day before and the day after this event. Moreover, I show that this decline came from lower expectations
about the future path of the short rate.

Surprisingly, the documented patterns are robust to a strong break in the operational procedure
of monetary policy in 1994. While monetary policy was not communicated directly to the public before 1994 but instead through open market operations, the Fed became increasingly transparent thereafter. This hints towards a mechanism that could explain the documented behavior of long-term yields:
FOMC meetings, in addition to revealing important information, might serve as a coordination device,
such that market participants update their expectations about the evolution of interest rates around
these dates.

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