Will bond investors get their tour guide back at Jackson Hole?

Summer travelers prefer curated experiences. That’s the message from travel agents, who find that clients will pay more when offered a comprehensive itinerary and local guide to eliminate stress and ensure there will be no surprises. The same is true of fixed-income investors. Give them a sense of where short-term rates are headed and how fast they’re likely to get there and they’ll pay up for notes and bonds across the curve, as demonstrated by the collapse in Treasury term premia during the era of Fed forward guidance (Figure 1).

Figure 1: Who doesn’t like curated experiences?

Academics distinguish between central bank transparency (the stipulation of its targets and “reaction function”) and “forward guidance” (communications to influence yields outside of policymakers’ direct control). But the two have become indistinguishable in practice, because the Fed’s inaugural post-FOMC press conference (April 2011) arrived when policy rates were already pinned near zero. From its outset, the FOMC press conference has been used as a tool to shape market outcomes.

With unemployment running above 9% in Q1-2011, the Fed expected overnight interest rates to stay near zero for a long time to come. Yet, five- and ten-year Treasury yields remained above 2% and 3.25%, respectively, implying that the market expected liftoff would happen much sooner. The Fed used its FOMC statements and press conferences to disabuse market participants of this notion, insisting that rates would remain low and encouraging traders to arbitrage away the 185-basis point spread between the 5-year yield and short-term rates. This was great advice: the annualized return on a repo-financed 5-year note was 42% when it matured in 2016! Traders profited and the Fed got the easing it sought.

The same playbook yielded different results during the pandemic. Once again, the Fed pledged to keep rates near zero and put its money where its mouth was, buying massive quantities of Treasury securities at prices that only made sense if it delivered on that commitment. But economic fundamentals couldn’t have been more different. The Fed held out as long as it could, but the eventual rate shock of 2022-23 blew up trades that proved so successful a decade prior.1 Investors learned it was not just inflation they had to worry about, but Fed policy adjustments necessary to stabilize inflation.

Consider the plight of an investor who correctly surmised that Fed policy was too easy and bought TIPS (Treasury inflation-protected securities) to hedge inflation risk in January 2021. The security worked as advertised, delivering a 17.4% principal uplift by October 2023, but that benefit was overwhelmed by the sharp rise in real yields, which shaved 25% off the market value of 10-year TIPS. Being hedged against inflation provided no hedge against the sharp rise in real interest rates necessary to bring inflation down (Figure 2).

Figure 2: TIPS investors overlooked the cost of inflation stabilization

That experience seems especially relevant today, as investors fret about the potential upward pressure on rates from diesel shortages, AI-related capex, waning foreign demand for Treasuries, and enormous structural deficits. With forward real yields now above 2.5% (Figure 3), TIPS incorporate a healthy premium to compensate holders for the risk that the Fed will again be forced to hike aggressively to bring inflation to heel or induce additional domestic savings. That real term premium – rather than inflation compensation – explains why Treasury yields are as high as they are today.

Figure 3: Bondholders seek protection from another real rate shock

Amid such unease, silence from the Fed is deafening. Expecting the curated experience they’ve enjoyed for the past 15 years, fixed-income investors are behaving like tourists who’ve landed in Borneo without the detailed itinerary and guide that was promised. They want to see the orangutans and clouded leopards, but not if they have to venture into the jungle alone.

Even after the 2022-23 shock, the Fed was able to soothe fixed-income investors’ nerves with talk of a mythological “neutral rate” and imagined threats to the labor market. The force of these narratives and their contagious spread among Fed watchers convinced bondholders to look past persistent inflation overshoots and obvious fiscal imbalances. Surely this Fed can conjure a narrative framing that offers nervous travelers reasons to think the situation remains under control.