How Federal Funds Rate Changes Affect Treasury Yields and Coupons
Summary
The document explains how changes in the federal funds rate can influence US government bond yields and prices. Monetary policy tends to affect short maturities most directly: higher overnight borrowing costs can lift rates across nearby maturities, which can lower prices of existing fixed coupon bonds. New bonds may be issued with coupons reflecting market yields at the time, while the coupons on already issued fixed rate bonds generally do not reset with the policy rate.
Longer maturity yields also reflect expectations for growth and inflation, along with a term premium for uncertainty about future inflation. The answer illustrates this distinction with a historical description of yield curve movements from 2015 to 2017, including periods when short rates rose while longer rates moved differently. The account is qualitative and tied to that period; it does not provide a formal model, quantify rate sensitivities, or establish that policy changes alone caused the observed curve shifts.
Key ideas
- Federal funds rate changes tend to influence short term Treasury yields most directly.
- Existing fixed coupon bond payments generally remain unchanged when the policy rate moves.
- Newly issued bonds may have coupons that reflect prevailing market yields.
- Long maturity yields also respond to growth and inflation expectations and a term premium.
- Yield curve movements can diverge across maturities as these influences change.
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Full text
# What is the connection between the federal funds rate and US government bonds # What is the connection between the federal funds rate and US government bonds If the Federal Funds Rate changes, does that affect bond prices? How? Also, is there any connection between the Federal Funds Rate and the coupon payment on US bonds?(for those that have a coupon payment) When the Federal Funds Rate is changed, is there also a chance in the coupon paid by bonds issued after that? ## Answer by Tom (score 2, accepted) https://quant.stackexchange.com/a/35450 The fed funds rate is the rate setting mechanism that affects all rates along the curve, however it mainly influences short term rates. If overnight borrowing costs are going up, then its going to cost more to borrow for 1m, 3m, 6m, 1yr, 2yr. The short end of the curve isn't affected by long term growth and inflation assumptions as much as the long end of the curve, its mainly driven by monetary policy (the fed funds rate). ie, 2% annual inflation isn't going to eat away as much at a 2yr coupon bond as it would with a 30yr bond. Long term rates also have a term premium, which is compensation for the uncertainty in future inflation. Here's a chart (as of yesterday 8/2/2017) that shows how the yield curve has changed over the last 2yrs in response to monetary policy and long term growth/inflation assumptions. Visualizations usually help me so hopefully this will allow you to understand. As you can see, short term rates have gone up considerably since August 2015. However as you go further out on the curve, the rate differential starts to decrease, which implies (IMO) that long term growth and inflation expectations are roughly the same as what they were 2yrs ago. If you follow the markets, think back to the summer of 2016 when rates were extremely low, with negative yields in the trillions of dollars. There was an interest rate increase in Dec 2015, so the short end of the curve is shifted up, but the long end got hammered, meaning the growth and inflation expectations at that time were abysmal (Roughly a month after Brexit, US election coming up, QE by central banks etc etc). Looking at the six month curve, The "Trump Bump" was still in affect, with the global inflation outlook on the rise. As that has clearly died down, its left us with where we are today. Another rate increase, but much future expectations, causing the steepness of the curve to flatten.
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