How to Track US Monetary Policy and Economic Expectations? - Huxiu#
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How to Track US Monetary Policy and Economic Expectations?#
After the September 2023 interest rate meeting, global capital markets experienced significant turbulence. On the one hand, the ten-year US Treasury yield rose sharply, surpassing 4.50% at one point.
On the other hand, equity markets in various countries underwent significant adjustments, with the S&P 500 index falling by 2.56% in just two trading days.
In this interest rate meeting, the Federal Reserve did not raise interest rates and kept the federal funds rate unchanged at 5.25%-5.50%. So why did US stocks and bonds experience such volatility? It's because the Federal Reserve significantly raised its economic expectations for 2024 and adjusted the dot plot, reducing the number of expected rate cuts in 2024 from 4 to 2.
- Adjustment of economic expectations.
- Dot plot.
At this point, many investors may still wonder: What's the big deal about adjusting the dot plot? After all, there was no interest rate hike.
Also, didn't the Federal Reserve raise its outlook for the economy in 2024? Why did US stocks drop so much?
This article will address these questions.
The Essence of US Monetary Policy
In fact, the federal funds rate is not the essence of US monetary policy; it is just one component. The essence of US monetary policy lies in the expected path of the federal funds rate in the next 1-2 years.
In other words, the current federal funds rate is important, but the future changes in the federal funds rate are even more important.
Therefore, adjusting US monetary policy is not about adjusting a single point, but about adjusting the entire line.
As shown in the above graph, we should not focus on individual points, but on the entire line. However, expressing the entire line is too cumbersome, so we can focus on the area enclosed by the curve and the x-axis, which represents a certain comprehensive aspect of the line.
Generally, this area represents the two-year Treasury yield, in other words, the two-year Treasury yield is the essence of US monetary policy.
An Unconventional Rate Hike
Previously, we were familiar with rate hikes that adjusted the current federal funds rate. However, there is another unconventional rate hike that adjusts future rate cut expectations.
As shown in the graph above, in this interest rate meeting, the Federal Reserve postponed the timing of rate cuts in 2024 from July to November, resulting in a significant increase in the internal area - the orange area - which raised the implied two-year Treasury yield in the dot plot.
We can calculate the implied two-year Treasury yield based on different dot plots using an Excel spreadsheet.
- Rate cuts starting in July next year correspond to an implied two-year Treasury yield of 4.94%.
- Rate cuts starting in November next year correspond to an implied two-year Treasury yield of 5.22%.
In other words, although the Federal Reserve did not raise interest rates, it raised the implied two-year Treasury yield from 4.94% to 5.22% by adjusting the dot plot, which means the implied rate increased by 28 basis points.
Different Market Views on Economic Expectations
However, the Federal Reserve cannot adjust its guidance arbitrarily; it needs to follow certain rules.
Generally, it needs to make economic projections for the future and then set an expected rate hike path based on these projections.
Therefore, the most important document in each interest rate meeting is the "Economic Projections."
Thus, we have a logical chain: the Federal Reserve's economic outlook - the dot plot - the official guidance for the two-year Treasury yield.
However, the economy is a future matter and has a lot of uncertainty. The Federal Reserve's economic outlook is not the only correct answer, and different market participants will express their own views.
So how does the market express its views? If it is more optimistic than the Federal Reserve's expectations, it will delay the timing of rate cuts; if it is more pessimistic, it will bring forward the timing of rate cuts.
As shown in the graph above, this time the market revised downward based on the official yield of 5.22%, indicating that the market does not believe the economy is as good as the Federal Reserve claims. Therefore, the market yield for the two-year Treasury is 5.14%, 8 basis points lower than the official guidance.
The True Meaning of the Two-Year Treasury Yield
By understanding the official guidance for the two-year Treasury yield and the market's adjustments based on it, we can draw the following conclusion:
The two-year Treasury yield combines two major factors of the US: 1) the Federal Reserve's monetary policy, and 2) the capital market's expectations for the US economy.
Once we understand this, we can understand that the best indicator related to the stock market is the two-year Treasury yield, not the ten-year Treasury yield.
The trend on the first trading day after the interest rate meeting showed this, with the S&P 500 index falling and the two-year Treasury yield declining.
However, the ten-year Treasury yield was rising.
So why did this happen? It's because the ten-year Treasury yield incorporates more factors, including but not limited to: 1) overseas factors, 2) US fiscal issues, 3) geopolitical factors, and so on.
Conclusion
In summary, compared to the ten-year Treasury yield, the two-year Treasury yield is cleaner and only includes US domestic factors: 1) the Federal Reserve's expectations for the US economy, and 2) the capital market's expectations for the US economy.
However, the factors affecting the ten-year Treasury yield are much more complex.
The above graph only represents a part of the various factors and does not take into account factors such as the US Treasury Department and central banks' preferences for gold.
The two-year Treasury yield is clean, while the ten-year Treasury yield is not. Understanding this logic helps us understand why every time US stocks plummet, it is related to the steepening of the US yield curve.
Because the driving factors are all within the US, the capital market observes more signs of weakness in the US economy, leading to a stock market decline and a steepening of the yield curve in the bond market.
Currently, the US yield curve has steepened rapidly.
In addition, since the two-year Treasury yield is so important, why should we still pay attention to the more complex ten-year Treasury yield? It's because we are international investors, and the ten-year Treasury yield affects the pricing of assets in various countries.
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