Paradoxical Responses to Fedspeak

Throughout November, the US Treasury bond market seems to have been responding to Fedspeak by going in the opposite direction from what Fed statements would suggest about interest rates. Early in the month, when Fed officials were sounding (to my ears, anyhow) hawkish, interest rates fell. Over the past few days, with Fed officials sounding more dovish, interest rates have risen.

With respect to long-term bonds, this behavior is consistent with a view in which statements by Fed officials give clues about the Fed’s degree of commitment to keeping inflation low. Hawkish statements mean less inflation, which means lower long-term interest rates. Dovish statements mean more inflation, which means higher long-term interest rates.

It’s a bit harder to rationalize the response of short-term bonds (by which I mean 2-year Treasury notes, Treasury bills, and seasoned securities nearing maturity). The Fed’s commitment to keeping inflation low shouldn’t be much of an issue here, because there isn’t enough time for the inflation to develop before the bond matures.

Another explanation is flight to quality: when the Fed is more hawkish, bondholders worry more about the creditworthiness of other borrowers and shift their assets into Treasury securities, causing the interest rates on those securities to fall. But even the Eurodollar market, which is considered more risky than the Treasury market, has been responding in the same direction.

A variation on the flight to quality explanation is that the flight is from stocks: hawkish statements by the Fed cause investors to sell stocks and replace them with bonds, thus causing bond yields to fall. But presumably the reason investors sell stocks is that they think higher interest rates are bad for the stock market. Why would this cause them to bid down interest rates to an even lower level? Once interest rates fall, wouldn’t they immediately go back into stocks?

My best guess about what’s going on is that the bond market thinks it understands Fed policy better than the Fed does. The bond market is convinced that interest rates will eventually have to come down to prevent, or to recover from, a recession. The sooner the Fed starts cutting – the sooner it sets into motion the recovery process – the less cutting it will eventually have to do. In particular, if the Fed cuts sufficiently at the next two meetings, it may be able to avoid a recession. If not, a recession is nearly certain, and more dramatic (and longer lasting) cuts will be necessary to recover from the recession. This is how I imagine that the bond market reasons, but I’m not convinced that the bond market is right.