Break into Wall Street Technical preparation
Rates and the Fed
Rates questions come up in sales and trading, fixed income research and macro roles, and increasingly in banking. Interviewers want the mechanics: how the Federal Reserve sets its rate, how markets price its next move, and what a change in yields does to a bond.
What you must know
- How the Fed sets its rate
The Federal Open Market Committee meets eight times a year on a set schedule and can meet in between. It sets a target range for the federal funds rate, the rate banks charge each other for overnight loans of reserves. It keeps the market rate inside that range mainly through the interest it pays on reserve balances and the rate on its overnight reverse repurchase facility. Its mandate is maximum employment and stable prices, which it defines as 2% inflation measured by the personal consumption expenditures price index.
- The balance sheet is a second tool
Quantitative easing means buying Treasuries and agency mortgage-backed securities to push down longer-term yields. Quantitative tightening means letting those holdings run off, which works in the other direction. The policy rate steers the short end of the curve; the balance sheet and guidance about future policy act more on the long end.
- The yield curve
The yield curve plots government bond yields by maturity. Long yields reflect the expected path of short rates plus a term premium for tying money up longer, so the curve usually slopes upward. When short yields rise above long ones, the curve is inverted: markets expect policy rates to fall, often because they expect a slowdown. Inversions have preceded most US recessions in recent decades, but the lag is long and variable, and they are not infallible.
- Duration and convexity
Modified duration is the approximate percentage change in a bond's price for a 1 percentage point change in its yield, with the opposite sign. Longer maturities and lower coupons mean higher duration. Convexity measures how duration itself changes as yields move: for an ordinary bond it makes price gains from falling yields larger than losses from rising yields of the same size.
- Real yields and breakevens
Treasury Inflation-Protected Securities (TIPS) pay a real yield, above inflation. The gap between a nominal Treasury yield and the TIPS yield of the same maturity is the breakeven inflation rate: the average inflation at which the two would return the same. It is a market gauge of inflation expectations, though it also contains risk and liquidity premia.
- Current levels on the site
This page stays evergreen and quotes no current levels. For where the policy rate, the curve and market pricing for upcoming meetings stand today, use the Andra Markets Fed & Rates section.
Worked example
A bond's price when yields move 1%
A bond priced at $100 has a modified duration of 7.0 and a convexity of 60. Estimate its price if yields rise or fall by 1 percentage point, using price change ≈ −duration × change in yield + ½ × convexity × (change in yield)².
| Line | Yields rise 1% | Yields fall 1% |
|---|---|---|
| Starting price | $100.00 | $100.00 |
| Change in yield | +1.00% | −1.00% |
| Duration effect (−7.0 × change) | −7.00% | +7.00% |
| Convexity effect (½ × 60 × 0.01²) | +0.30% | +0.30% |
| Estimated price change | −6.70% | +7.30% |
| Estimated new price | $93.30 | $107.30 |
Duration alone gives $93.00 and $107.00. Convexity adds 0.30% in both directions, so the bond gains more than it loses for the same move. On a $10 million position the loss for a 1% rise is about $670,000.
Practice
Answer out loud first, then check. Mark each card; the ones to review come back first next time.
How does the Fed set interest rates?
The Federal Open Market Committee sets a target range for the federal funds rate, the overnight rate banks charge each other on reserves. It meets eight times a year. It does not fix the market rate directly: it sets the interest it pays on reserve balances and the rate on its overnight reverse repo facility, which keep the effective rate inside the range, because banks will not lend for less than they can earn at the Fed.
Likely follow-up: What is the Fed's mandate, and how does it measure inflation?
How does a cut in the policy rate reach the economy?
Through several channels. Borrowing costs fall for households and companies, encouraging spending and investment. Asset prices rise, which makes people feel wealthier. The currency tends to weaken, which helps exporters. Banks may lend more readily. And expectations shift: if people believe the Fed will support growth, they act on it. The effects arrive with long and variable lags, often a year or more.
Likely follow-up: Why might a cut not lower mortgage rates?
What is the yield curve, and why does an inversion matter?
It plots government bond yields against maturity. It normally slopes upward because investors want extra yield, the term premium, to lend for longer. An inversion, where short yields exceed long ones, usually means markets expect the central bank to cut rates later, typically because growth will weaken. It has preceded most US recessions in recent decades, but with a long and uneven lag, so it is a signal, not a timetable.
Likely follow-up: Which two points of the curve do people usually watch?
What are bull and bear steepeners and flatteners?
Bull means yields fall and prices rise; bear means yields rise. A bull steepener is short yields falling more than long ones, typical when markets start to price rate cuts. A bear steepener is long yields rising more than short ones, often from inflation worries or heavy government borrowing. A bear flattener is short yields rising faster, typical when the Fed is hiking. A bull flattener is long yields falling faster, often in a growth scare or when the long end is in demand.
Likely follow-up: Which would you expect on a day the Fed surprises with a cut?
Why do bond prices fall when yields rise?
A bond's coupons are fixed. If new bonds offer a higher yield, an existing bond has to fall in price until its yield matches, otherwise nobody would buy it. Mathematically, its price is the present value of fixed cash flows, and a higher discount rate lowers that value. The longer the bond, the more cash flows are discounted over many years, so the larger the price move.
Likely follow-up: Which moves more for a 1% yield change: a 2-year or a 30-year bond?
What is duration?
Macaulay duration is the weighted average time until a bond's cash flows are received, in years. Modified duration converts that into price sensitivity: the approximate percentage change in price for a 1 percentage point change in yield. A zero-coupon bond's Macaulay duration equals its maturity; coupons pull duration below maturity. Traders often use DV01, the dollar change in price for a one basis point move.
Likely follow-up: What is the DV01 of a $10 million position with a modified duration of 7?
A bond priced at $100 has a modified duration of 7. Yields rise by 1%. What is the new price?
Roughly 7% lower, so about $93. If you are given convexity, say 60, add ½ × 60 × 0.01², which is 0.3%, so the estimate becomes a fall of 6.7% and a price of $93.30. Duration is a straight-line approximation; convexity corrects for the curve in the price to yield relationship.
Likely follow-up: And if yields fall by 1%?
What is convexity, and when can it be negative?
Convexity measures how a bond's duration changes as yields move. For an ordinary bond it is positive: duration rises as yields fall, so price gains are larger than losses for the same move, which investors value.
It can be negative for callable bonds and mortgage-backed securities. When yields fall, borrowers refinance or issuers call the bond, so the upside is capped, while the downside when yields rise remains.
Likely follow-up: Why does a mortgage-backed security's duration rise when rates rise?
What are real yields and breakeven inflation?
A real yield is the return above inflation, observed on inflation-protected bonds such as TIPS. Breakeven inflation is the nominal Treasury yield minus the TIPS yield of the same maturity. With hypothetical figures, a 10-year Treasury at 4.0% and a 10-year TIPS at 1.8% give a breakeven of 2.2%: the average inflation rate at which the two bonds return the same. It is a gauge of inflation expectations, blurred by liquidity and risk premia.
Likely follow-up: Why do real yields matter for equities and gold?
How do fed funds futures price the next meeting?
A fed funds future settles on the average effective fed funds rate over its contract month, and its price is 100 minus that rate. If the effective rate is 3.00% and a meeting falls at the very start of the month, a price of 97.125 implies an average rate of 2.875%, halfway to a 25 basis point cut, so the market prices roughly a 50% chance of the cut.
When the meeting is mid-month, weight the days before and after it: implied average = (days before × current rate + days after × post-meeting rate) ÷ days in the month, and solve for the post-meeting rate.
Likely follow-up: Why might these probabilities differ from what economists forecast?
If the Fed cuts rates, will the 10-year yield fall?
Not necessarily. The 10-year yield reflects the expected average policy rate over ten years plus a term premium. If the cut was already priced, little changes. If markets see the cut as risking higher inflation, or if government borrowing is heavy, the term premium can rise and the 10-year yield can rise even as short rates fall, steepening the curve.
Likely follow-up: What is the term premium, and why does it change?
What is the difference between quantitative easing and cutting rates?
Cutting rates lowers the overnight rate and steers the short end of the curve and expectations. Quantitative easing is the central bank buying longer-dated bonds, reducing the supply available to investors and pushing down longer yields and the term premium. QE is used mainly when rates are already near zero or markets are dysfunctional. Quantitative tightening reverses it by letting holdings mature without reinvesting.
Likely follow-up: How does QE affect bank reserves?
How would you prepare for a question on the Fed in an interview?
Know the current target range, the date and outcome of the last meeting, what the market prices for the next one, and the latest inflation and jobs figures, with one sentence on what each means for policy. Then have a view: what the Fed is likely to do and what would change that. Check the figures on the day, from the site's Fed & Rates section or the Fed's own statements.
Likely follow-up: What data would most change your view?
Common mistakes
- Saying the Fed sets the fed funds rate directly: it sets a target range and administers rates that keep the market rate inside it.
- Forgetting the sign: bond prices move the opposite way to yields.
- Using duration alone for a large yield move and calling the answer exact.
- Reading an inverted curve as a recession date.
- Assuming a rate cut always lowers long yields.
- Quoting rate levels from memory. Check them on the day of the interview.