How the Federal Funds Rate Affects 10 Year Treasury Bond Yields

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How the Federal Funds Rate Affects 10 Year Treasury Bond Yields ______________________________________________________________________ I. Introduction The Federal Open Market Committee raised the federal funds target interest rate from the historically low 1% to 1.25% at its meeting in June 2004. Macroeconomic theory tells us that long-term interest rates tend to move in the same direction, and generally in concert with, shortterm interest rates (Abel 2005). So, we would expect the yield on a long-term asset like the10year Treasury bond, which moves directly with interest rates, to move up when a short-term rate like the federal funds rate moves up. However, a cursory reading of financial news sources since the FOMC began its rate hike policy, through January 2005, show that the yield on the 10- year has actually fallen. This study will develop a predictive model to describe this direct influence and conclude that the federal funds rate directly influences the 10-year Treasury bond yield. This study will not try to predict what factors could be holding the yields down in any quantifiable way. The 10year Treasury bond yield is a benchmark rate, important to bond investors looking for future indicators of inflation, and to areas such as housing and other loans; a predictive model will allow investors to more adequately gauge investment risk and loan officers to judge what interest rates to charge Section II will present a brief review of the literature concerning these issues while helping to describe some decisions made in the current study. Section III will present the results of the data collection and analysis used to support our conclusions. The regression model will be described, and the predictions explained, with supporting evidence from the actual data. Section

How the Federal Funds Rate Affects 10 Year Treasury Bond Yields

Kane Snyder

5/2/2005

1

IV will be a conclusion reestablishing our conclusions and also pointing out some of the aspects of the current study that caused some concern and that may warrant further investigation.

II. Review of the Issue There is some writing in the literature concerning how monetary policy affects asset prices, namely stocks and bonds. There are also studies that suggest the federal funds futures contract, the rate that people speculate the federal funds target rate will move to in the near term, is an indicator of monetary policy and the financial market’s reaction to such information. Fleming and Remolona (1997) use high frequency, intraday price activity to look at how announcements of events like the federal funds rate target, the employment numbers, the producer price index, and the consumer price index affect and contribute to price shocks and trading volume in the bond market. They found the federal funds rate target to be significant in their regressions, and that of the 25 greatest price shocks between 1993 and 1994, three of them were direct results of an announcement of a new federal funds target rate. Even with the strength of these results, their study of the federal funds target rate and its affect on bond prices had not been discussed in the literature up to that point. The study by Gulley and Sultan (2003) examines the federal funds futures contract as an indicator of monetary policy. They find that positive and negative changes in the federal funds rate have symmetric effects on the bond market, which supports my assertion that the federal funds rate has a direct effect on the 10- year Treasury bond yield. Further, they suggest that their findings are consistent with the expectation that an increase in the federal funds rate translates into lower bond prices, or higher bond yields which move inversely to prices.

How the Federal Funds Rate Affects 10 Year Treasury Bond Yields

Kane Snyder

5/2/2005

2

Fleming and Remolona (1997) reference studies in the early...
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