Fed Rate Decision: How FOMC Meetings Affect Bond ETFs

Bond ETFs, such as the iShares 20+Year Treasury Bond ETF (TLT), have become popular trading vehicles for investors expecting to profit from price gains associated with rate cuts (bond prices have an inverse relationship with interest rates and bond yields). 

Federal Reserve interest rate decisions play an important role, not only in the bond market but also in the stock market and broader macro economy, as the central bank’s monetary policy impacts the bond prices and yields that in turn impact consumer and business borrowing.

What Is the FOMC and How Does It Impact Interest Rates?

The FOMC, or Federal Open Market Committee, is a powerful group within the Federal Reserve system that plays a critical role in setting monetary policy for the U.S. The FOMC's decisions to raise or lower the target federal funds rate and other monetary policy tools influence interest rates throughout the U.S. economy. These actions affect borrowing costs, economic activity and inflation. 

Here are some of the various ways the FOMC impacts interest rates.

• FOMC members: The FOMC consists of voting members, including the Chair of the Federal Reserve Board, Jerome Powell, the President of the Federal Reserve Bank of New York, John C. Williams, and a rotating group of other Reserve Bank presidents. 
• The FOMC’s role: Their primary responsibility is to conduct monetary policy by setting the target federal funds rate. This is the interest rate at which banks borrow and lend reserves to each other overnight. It's a key benchmark that influences other short-term interest rates in the economy. 
• The Fed’s dual mandate: The Federal Reserve has two key objectives, which are maximum employment and price stability. The former aims to promote a healthy job market by keeping unemployment at a low level while the latter focuses on controlling inflation and maintaining stable prices for goods and services over the long term. 
• FOMC meetings: The FOMC holds meetings eight times a year to assess economic conditions and determine the appropriate target federal funds rate. 
• Raising the rate: If the economy is overheating or inflation is rising, the FOMC might raise the target rate. This makes borrowing more expensive, which can slow down economic activity and dampen inflation. Banks typically raise their lending rates (mortgages, car loans, etc.) in response to a higher federal funds rate. 
• Lowering the rate: Conversely, if the economy is weak or facing deflation, the FOMC might lower the target rate. This encourages borrowing and spending, stimulating economic growth. Banks tend to lower their lending rates when the federal funds rate is reduced. 
• Open market operations: Buying and selling government bonds in the open market can affect short-term interest rates and the money supply. 
• Forward guidance: Publicly communicating the FOMC's future intentions regarding interest rates can impact investor expectations and market sentiment.

How Fed Rate Decisions Impact Bond ETFs

Federal Reserve decisions, particularly regarding the target federal funds rate, will influence bond ETFs depending on factors including the direction of rates and the bond funds’ holdings.  

Here's a breakdown of the relationship between Fed policy and bond ETFs.

• Rates and bond prices: When the Fed changes the target federal funds rate, it generally leads to changes in interest rates across the bond market. This can cause the prices of the bonds within the ETF to rise or fall, depending on the rate decision. 
• Inverse relationship: Interest rates and bond prices have an inverse relationship. For example, when interest rates fall, the value of existing bonds with higher fixed interest rates become more attractive compared to new bonds offering lower yields. This drives up the prices of existing bonds in the ETF. The opposite is true when interest rates are rising.

Types of Bond ETFs and Interest Rate Impact

The impact of Fed rate decisions can vary depending on the type of bonds held by the ETF. 

• Maturity of holdings: ETFs holding bonds closer to maturity might experience a less severe price decline compared to those with longer maturities.  
• Short-term bond ETFs: These are generally less sensitive to interest rate changes because they mature in one to three years and their reinvestment rates can adjust to the new environment. The largest short-term bond fund is the Vanguard Short-Term Bond ETF (BSV), and the largest ultra-short-term bond ETF is the SPDR Bloomberg 1-3 Month T-Bill ETF (BIL).
• Long-term bond ETFs: These are more susceptible to interest rate fluctuations as their fixed interest rates become less attractive when new, higher-yielding bonds are issued. The largest long-term bond ETF is the iShares 20+ Year Treasury Bond ETF (TLT).
• Credit quality: Bond ETFs might invest in bonds with varying credit ratings. Bonds with lower credit quality (high-yield or "junk" bonds) can be more volatile in response to interest rate changes. 

What Is the Fed’s ‘Dot Plot’?

The Fed's dot plot, formally called the Summary of Economic Projections (SEP), is a visual representation of the individual forecasts of FOMC members for the future path of the federal funds rate. The Fed's dot plot, which is released every other meeting, resulting in a nearly quarterly release frequency, helps investors and businesses anticipate the Fed's policy direction and make informed economic decisions. 

Here's a breakdown on how the dot plot works. 

• What it shows: The dot plot displays each FOMC member's prediction for the appropriate level of the federal funds rate at the end of each calendar year for the next few years (typically three) and the longer run (beyond that timeframe). Each dot represents an individual member's forecast, and their placement on the vertical axis signifies the predicted federal funds rate. 
• Why it matters: The dot plot provides valuable insights into the collective outlook of the FOMC on future interest rate policy. It indicates whether the FOMC expects to raise, lower or maintain the federal funds rate to achieve its economic goals of price stability and maximum employment. Investors and businesses closely watch the dot plot to gauge the Fed's monetary policy stance and make informed decisions about investments and economic strategies. 
• Limitations of the dot plot: The dots represent individual forecasts, not a single, unified prediction. There can be some spread in the projected rates across members. The dot plot reflects the FOMC's current thinking based on available information. Economic conditions can change, and the Fed might adjust its projections as needed. 

While the dot plot offers valuable information about the Fed's outlook, it's important to note that these projections are not commitments. They can change based on evolving economic conditions, including inflation trends, employment data and global economic developments.

For the most current information on upcoming FOMC meetings and dot plot releases, you can visit the Federal Reserve's official FOMC calendar.

Fed Dot Plot and 2025 Rate Forecast

The March Fed dot plot suggested its federal funds rate will fall from its current range of 4.25% to 4.5% to a range of 3.75% to 4% by the end of 2025.

March 2025 Dot Plot Highlights

• Interest rates: The median projection anticipates the federal funds rate to decrease by 50 basis points in 2025, bringing it to a range of 3.75%–4% by year-end. Further reductions are projected in 2026 and 2027, aiming for a longer-run neutral rate of 3%. 
• Inflation: The Personal Consumption Expenditures (PCE) inflation rate is projected to end 2025 at 2.7%, up from the previous estimate of 2.5%. This upward revision reflects concerns over persistent inflationary pressures, partly due to recent tariff implementations. 
• Economic growth: Real GDP growth for 2025 has been downgraded to 1.7%, a decrease from earlier projections of 2.1%. This adjustment indicates expectations of a slowing economy.
• Unemployment: The unemployment rate is expected to rise to 4.4% by the end of 2025, suggesting a softening labor market.

Rate Cut Outlook and Considerations

The Federal Reserve's projections underscore a cautious approach to monetary policy amid economic uncertainties. While rate cuts are anticipated, their timing and magnitude will depend on evolving data related to inflation, employment and economic growth. The next dot plot update is scheduled for June 17, which will provide further clarity on the Fed's policy trajectory.