“Forward guidance” has become an important US Federal Reserve (Fed) policy tool since short-term rates have fallen toward the zero boundary, and is now very much in the spotlight as markets focus on the end of quantitative easing (QE). Simply put, forward guidance is the act of a central bank communicating to the investing public their longer term intentions for the future pathway of the short term policy rate that they directly control (the overnight Fed Funds rate in the US). I am going to use the Fed as the example here, but much of this pertains to other countries too. Longer term Treasury yields, say the 10y, have two main components:
1) Evolution of the short rate: a return reflecting the market’s expectation of the average overnight Fed Funds rate compounded for the next 10 years.
2) Term premium: an extra return over #1 which compensates investors for tying up their capital for 10 years, instead of simply rolling overnight deposits daily as in a savings account. The term premium grows and shrinks with changes in investor risk tolerance.
In bringing down long term rates, the Fed would use forward guidance to affect perceived evolution of the short rate, and QE to affect the term premium. QE has compressed the term premium directly by increasing Treasury prices in the market place, and also indirectly by broadly reducing global investor risk aversion. In times of extreme QE intervention in markets, the term premium could be pushed negative. As discussions began to occur openly from the Fed and others about the end of QE, the 10y note moved from 1.6% to 2.35% in six weeks. In the mind of a central banker making no changes to his/her intended (distant) rate hiking path, the majority of this move should have been due to changes in term premium. This would be a big move, particularly given that QE purchases are still continuing at full throttle.
In fact, short term interest rate markets indicated that investors were reflecting an accelerated tightening of the policy rate, i.e. the bond sell-off was actually a reflection of a combined move in both the evolution of the short rate and the term premium. To the extent that markets are incorrectly reflecting the intended future path of monetary policy, e.g. an overshoot related to the taper-talk, then reinforcing forward guidance is likely to occur. This is an overt way for the Fed to remind investors that 2.35% for 10 years isn’t necessarily mispriced if, in cash, you would get zero for the first two years, and then only modest gradual increases thereafter.
On Wednesday we got rather firm forward guidance from Chairman Bernanke but with hawkishness in the background from other Fed governors. Detachment from yield levels justified by reasonable short rate expectations and term premium can persist during periods of risk aversion, and we are seeing that now.