The Golden Rule: During the next 12 months, will the Federal Reserve move interest rates by more or less than what is currently priced into the market? In this report we demonstrate that an investor who can correctly answer that question will very likely make the right bond market call. We call this framework for market analysis the golden rule of bond investing.

Exceptions: We identify a few periods when applying the golden rule correctly would not have led to the right market call. Such periods are rare, but they tend to occur when the market "fights the Fed". One such episode occurred as recently as 2017.

Total Return Forecasts: We use the golden rule framework to generate total return forecasts for Treasury indexes of all different maturities and many different spread product indexes.

It's easy to get lost in the sea of financial market news. Last week alone saw the suggestion of additional tariffs, weak housing data, strong consumer data, falling commodity prices and steep Chinese currency depreciation. It's not always obvious what's important for bond markets and what isn't.

While there is no miracle solution to this problem, we propose one helpful question that investors should always ask themselves to help discern the signal from the noise.

During the next 12 months, will the Federal Reserve move interest rates by more or less than what is currently priced into the market?

If you are able to answer that question correctly you will make the correct bond market call most of the time, and any new piece of information should be judged on how it impacts your answer. In fact, the framework of viewing everything through the lens of answering the above question works so well that we call it the golden rule of bond investing.

In this Special Report we illustrate the empirical success of the golden rule. We also draw on historical evidence to consider periods when the rule failed. Finally, we translate the golden rule into a method for forecasting total returns, and we generate total return forecasts for many different bond indexes, encompassing both Treasuries and spread product.

Testing The Golden Rule's Performance

Chart 1 on page 1 shows how well the golden rule has worked during the past 28 years. The top panel shows the 12-month fed funds rate surprise - the difference between the expected change in the fed funds rate that was priced into the market at the beginning of the 12-month investment horizon and the change in the fed funds rate that was ultimately delivered. A reading above zero indicates that the market expected a larger increase (or smaller decrease) than actually occurred, a reading below zero indicates that the market expected a smaller increase (or larger decrease) than actually occurred. The bottom panel shows 12-month excess returns from the Bloomberg Barclays Treasury Master Index relative to a position in cash.

Chart 1
The Golden Rule's Track Record
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If the golden rule works, then dovish fed funds rate surprises (positive values in Chart 1, shown shaded) will coincide with positive Treasury excess returns, and vice-versa. Chart 1 shows that this has indeed generally been the case.

Digging a little deeper, we find a strong positive relationship between 12-month Treasury excess returns and the 12-month fed funds rate surprise (Chart 2) and a similarly strong relationship using Treasury index price return instead of the excess return versus cash (Chart 3). Dovish fed funds rate surprises coincide with positive 12-month Treasury excess returns 87% of the time for an average excess return of +3.9%. They also coincide with positive Treasury price returns 76% of the time for an average price return of +2.1%. Hawkish surprises coincide with negative 12-month Treasury excess returns 61% of the time for an average excess return of -0.3%. They also coincide with negative Treasury price returns 72% of the time for an average price return of -1.9% (Table 1).

Chart 2
Treasury Index Excess Return &
Fed Funds Rate Surprises (1990 - Present)
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Chart 3
Treasury Index Price Return &
Fed Funds Rate Surprises (1990 - Present)
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Table 1
12-Month Treasury Index Returns And Fed Funds Rate Surprises (1990 - Present)
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Total Treasury returns also factor in coupon income, and are therefore often positive even when the price return is negative. Still, Table 1 shows that Treasury index total returns average +7.1% in periods with a dovish fed funds rate surprise and only +3.4% in periods with a hawkish surprise. Further, 65% of negative total return periods occurred when there was a hawkish fed funds rate surprise.

Of course, the golden rule is no panacea. The results presented above are impressive, but they assume that investors are able to correctly predict whether the market is over- or under-pricing the Fed. Making that determination remains a tall order.

The key insight to be gleaned from the golden rule is that if a piece of information does not alter your opinion about the future path of the fed funds rate relative to expectations, then it should probably be ignored. The golden rule is certainly not the "be all and end all", but it is a very useful first step.

Learning From Failures

While Table 1 shows that correctly determining the 12-month fed funds rate surprise allows us to make the correct bond market call most of the time, it also shows that it doesn't always work. To understand why the golden rule might fail, it is useful to think about why it works in the first place. To do this, let's first consider that any Treasury yield can be thought of as consisting of three components:

Treasury Yield = Fed Funds Rate + Expectations For Future Change In The Fed Funds Rate + Term Premium

Based on this formula, it is obvious that if rate expectations and the term premium are held constant, a higher fed funds rate translates directly into a higher Treasury yield, and vice-versa. This is one reason why the fed funds rate surprise correlates with Treasury returns.

The second reason that the fed funds rate surprise correlates with Treasury returns is that the expectations component of the above formula also tracks the fed funds rate surprise. In other words, investors are more likely to revise their rate expectations higher when the Fed is already in the process of delivering hawkish surprises. They are also more likely to revise their rate expectations lower when the Fed is delivering dovish surprises.

This dynamic is illustrated in Chart 4. The top panel shows the correlation between the 12-month fed funds rate surprise and changes in rate expectations as measured by our 12-month fed funds discounter. The two lines are mostly positively correlated, though they do occasionally diverge. The largest divergences appear near inflection points in monetary policy - e.g. when the Fed switches from hiking rates to cutting. Such inflection points are often prompted by economic recession.

Chart 4
When The Golden Rule Doesn't Work
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The bottom panel of Chart 4 shows the much tighter correlation between the 12-month fed funds rate surprise and the change in the average yield on the Treasury Master index. These two lines also occasionally diverge, but only during periods when rate expectations move strongly in the opposite direction of what is suggested by the rate hike surprise. Crucially, the abnormal change in rate expectations has to be so large that it more than offsets the impact from the change in the fed funds rate itself. Such periods are rare, though we did experience one as recently as last year.

Chart 5
The 2017 Example
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The 2017 Episode

Treasury returns in 2017 provide a textbook example of one of the rare periods when the golden rule failed. The Treasury Master Index returned +1.5% in excess of cash, even though the Fed lifted rates 25 bps more than the market expected at the beginning of the year. The reason for the divergence is that even though the Fed was in the process of lifting rates by more than what the market anticipated, the market continued to doubt the Fed's resolve and revised its expectations lower.

At the beginning of 2017 the market was priced for 51 bps of rate hikes for the year. Then, just as the Fed started to lift rates more quickly than that expectation would suggest, core inflation plunged (Chart 5). The market started to price-in that the Fed would react to falling inflation by turning more dovish, but as it revised its expectations lower the Fed continued to hike.

The end result is that the impact of the downward revision to rate hike expectations more than offset the upward pressure on yields from Fed rate hikes, and the Treasury index outperformed cash for the year.

Forecasting Total Returns

One final application of the golden rule is that it can be used as a framework for generating total return forecasts for different bond indexes. To illustrate how this is achieved we will walk through how we calculate such a forecast for the Treasury Master Index.

First, we note that the current reading from our 12-month fed funds discounter is 79 bps. This means that the market expects 79 bps of Fed rate hikes during the next 12 months. If we assume that the Fed will lift rates by 100 bps during the next 12 months, then we have a hawkish fed funds rate surprise of 21 bps. As an aside, Chart 6 shows that we have consistently witnessed hawkish fed funds rate surprises since mid-2017, and our 12-month discounter has increased, as is typically the case. But this also means that the bar for further hawkish rate surprises is now much higher.

Chart 6
Market Has Underestimated
The Fed In Recent Years
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We already demonstrated the strong correlation between the 12-month fed funds rate surprise and the 12-month change in the average yield from the Treasury index (see Chart 4). This allows us to translate our assumed fed funds rate surprise into an expected change in the index yield. In this case, that expected change in yield is +19 bps.

With an expected yield change in hand, it is relatively simple to calculate an expected total return using the index's yield, duration and convexity:

Expected Total Return = Yield - (Duration*Expected Change In Yield) + 0.5*Convexity*E(ΔY2)

E(ΔY2) = 1-year trailing estimate of yield volatility

In our scenario where we assume the Fed lifts rates by 100 bps during the next 12 months, the above formula spits out an expected total return of +1.60% for the Treasury Master Index.

Table 2 shows total return forecasts using this same method but with many different rate hike assumptions. For example, if we assume only 50 bps of Fed rate hikes during the next 12 months we get an expected Treasury Index total return of +3.37%.

Table 2 also displays total return forecasts for different maturity buckets within the Treasury Master index. These forecasts are all generated using the same method, but we correlate the 12-month fed funds rate surprise with different Treasury yields in each case. One caveat here is that the correlation between the fed funds rate surprise and the change in Treasury yield declines as we move into longer maturities (Appendix A). This is because long-dated yields are less directly connected to near-term changes in the fed funds rate. As such, there is more uncertainty surrounding the total return forecasts for long maturity sectors.

Table 2
Treasury Index Total Return Forecasts
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Spread Product Total Return Forecasts

With one additional assumption we can also apply our return forecasting method to different spread product indexes. That additional assumption is for the expected change in the average index spread. Using Table 3, you can simply pick a column based on the number of Fed rate hikes you expect during the next 12 months and pick a row based on whether you think spreads will remain flat, widen or tighten.

Table 3
Spread Product Total Return Forecasts
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For example, if the Fed lifts rates by 100 bps during the next 12 months and investment grade corporate bond spreads stay flat, we would expect investment grade corporate bond index total returns of +2.9%. For each sector, the spread widening scenario assumes that the average index spread widens to its highest level since the beginning of 2016 and the spread tightening scenario assumes the average index spread tightens to its lowest level since the beginning of 2016. All the spread scenarios are depicted graphically in Appendix B. For the High-Yield sector we make the additional adjustment of subtracting expected 12-month default losses from the average index yield.

Ryan Swift, Vice President
U.S. Bond Strategy
rswift@bcaresearch.com

Appendix A

Chart 7
Change In 1-Year Yield Vs. 12-Month
Fed Funds Rate Surprise
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Chart 8
Change In 2-Year Yield Vs. 12-Month
Fed Funds Rate Surprise
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Chart 9
Change In 3-Year Yield Vs. 12-Month
Fed Funds Rate Surprise
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Chart 10
Change In 5-Year Yield Vs. 12-Month
Fed Funds Rate Surprise
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Chart 11
Change In 7-Year Yield Vs. 12-Month
Fed Funds Rate Surprise
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Chart 12
Change In 10-Year Yield Vs. 12-Month
Fed Funds Rate Surprise
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Chart 13
Change In 30-Year Yield Vs. 12-Month
Fed Funds Rate Surprise
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Appendix B

Chart 14
Corporate Bond Spread Scenarios
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Chart 15
Government-Related Spread Scenarios
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Chart 16
Structured Product Spread Scenarios
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