When monetary policymakers act, what happens to bond yields? There are good theoretical reasons why shorter-term bond yields should be affected by monetary policy. Open market operations of the Federal Reserve System have an immediate effect on the federal funds rate, which is the interest rate charged for overnight interbank loans. Since short-term borrowing (such as a one-month loan) acts as a reasonably close substitute for overnight borrowing, an increase in the federal funds rate should be accompanied by an increase in other short-term interest rates. However, it is less clear why monetary policy should have a significant effect on five-, ten-, and 15-year bond yields. It seems doubtful that five-year loans are close substitutes for overnight borrowing. Yet, casual observation suggests that monetary policy actions are associated with changes in long-term bond yields.
Consider the bond market debacle of 1994. Publications ranging from Barron's to the Los Angeles Times argue that 1994 was the worst year for the bond market since the 1920s. In figure 1, we display the one-year holding period returns for zero-coupon bonds of four years, six years, and ten years in maturity.(1) (The vertical lines toward the right-hand side of each panel indicate January 1994.) If we exclude the volatile period from 1979-82 (when the Federal Reserve experimented with direct targeting of monetary aggregates), the one-year cumulative losses in late 1994 were among the worst of the postwar period. This collapse of bond prices took its toll on well-known bond investors: Michael Steinhart's hedge fund sustained losses of 30.5 percent in 1994, George Soros's fell 4.6 percent, and Julian Robertson's fell 8.7 percent - all coming off very strong performances in 1993.
At the same time, 1994 was a period of concerted monetary tightening. After a period during which the federal funds rate was exceptionally low and stable, the Federal Open Market Committee (FOMC) raised the funds rate rapidly. As shown in figure 2, the 18 months from mid-1992 through the end of 1993 were characterized by a federal funds rate near 3 percent, with very little variability. This period more closely resembles the mid-1960s than the more volatile 1970s and 1980s. From February 1994 through February 1995, the FOMC doubled its target for the funds rate from 3 percent to 6 percent in seven increments. Figure 2 shows that this sort of monetary tightening is hardly unusual (even excluding the 1979-82 period, when the federal funds rate was not the monetary policy instrument). Nonetheless, the congruence of these two events (the rapid tightening of monetary policy and the precipitous rise in long-term bond yields) led some to assert that the collapse in the bond market was policy induced. For example, the Wall Street Journal of December 13, 1995 graphically describes February 1994 as the month "when the Fed began raising short-term interest rates and set off the year's bond-market slaughter."
In this article, we will look at the relationship between monetary policy and long rates during the postwar period, and then apply what we learn to the extraordinary events of 1994. To examine how a monetary policy action (such as an increase in the federal funds rate) affects the yields of bonds with differing maturities, we must confront the problem of causality. For example, suppose we find that a tightening of monetary policy is associated with higher long-term bond yields. Can we then infer that tighter monetary policy causes higher yields? Not necessarily. It is generally believed that the FOMC tends to tighten monetary policy when there are indicators of future inflation. It is also believed that expectations of higher inflation tend to increase current bond yields. The positive correlation between tighter money and higher yields could be evidence that the Fed causes yields to increase when it tightens money, or it could be evidence that both the Fed action and the higher yields are jointly caused by forecasts of higher inflation. …