
Is the Fed a Fade?
Jan 13, 2025
In the final months of 2024 the world witnessed a perfect storm of bond market volatility that had never happened before over the past 40 years. Not once.
The impossible occurred when the U.S. Federal Reserve began lowering the policy Fed Funds rate, yet rates along the entire yield curves of mortgages and Treasuries leaped higher in response, according to data from the Federal Reserve, U.S. Treasury Department and Freddie Mac.
This behavior is called a Bear steepening, which often happens when the Fed has stopped lowering rates and the market expects inflation to increase as a result. The policy is held steady and yet the longer term instruments price in an inflation premium. But for that to happen in the midst of a Fed easing cycle is unheard of. In fact, the Fed has projected further a lowering of rates in the coming year, yet market participants continue to push rates higher.
The illogic of this market behavior can be explained by simple arithmetic. Assume that all bonds are traded with borrowed money, as they are when dealers trade them. When the Fed lowers the Funds rate, that decreases short-term borrowing costs. This makes owning a longer maturity instrument more profitable because it can be financed more cheaply yet has the same yield. Logic dictates that when a strategy becomes more profitable, it attracts more investors, who then use the “cheap” money to buy more bonds, thereby driving up the price of the bonds. Since bond prices are inversely related to interest rates, this drives down the interest rates. Hence when the Fed lowers rates, all other rates have typically followed suit.
For the past 40 years, at least, that has been the case. But see Figure 1 below. The Fed is shown cutting the Funds rate since September, yet all other rates are increasing. A look at Figure 2 shows that this has never happened before over the past 40 years, which has been the time when the bond market has matured in size and efficiency. Contrary to this behavior, the market should be more logical as it grows and matures.
Unfortunately for Gnomon Alpha, its Fed models did not account for a market that would move inversely to Fed Policy. Heading into the fourth quarter, Gnomon had 40 percent of its risk in fixed income, which paid handsomely leading up to that time. The Fed models predicted that the mantra “Don’t Fade the Fed” would once again work its magic. For the first time in 40 years, that rule was dramatically broken. Is the new rule “The Fed is a Fade?”

Figure 1: EFFR, 2Y Yield, 10Y Yield, 20Y Mortgage Rate from 2024 to 2025 YTD

Figure 2: EFFR, 2Y Yield, 10Y Yield, 20Y Mortgage Rate from 1982 to 2025 YTD
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