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How Rate Changes Affect Bonds
From the Baltimore Clubhouse – If you want to make money in bonds, you have to keep a close eye on the Federal Reserve.
Rob Morgan, The Oxford Club’s new Bond Strategist, does exactly that. Rob has been in the investment business for more than three decades and ran a $160 million taxable bond fund. Needless to say, he’s been watching the Fed very closely for a long time.
In today’s Market Wake-Up Call, Rob gives us his prediction of what the Fed is likely to do in 2020.
And if you’ve ever thrown a stone into a pool of standing water, you’ll understand how the Fed’s rate policy affects the economy.
Think of the economy as the pool of water and the federal funds rate – the base rate at which banks may lend to each other overnight – as the stone.
The Fed’s mandate is to smooth the business cycle by mitigating extreme contractions or expansions. Its main policy lever is the federal funds rate, which it can raise or lower.
Such changes cause ripple effects in the economy that start with interest rates and radiate toward inflation, unemployment and gross domestic product growth.
The Fed can’t be too heavy-handed or it may cause unintended splash-back. So it generally prefers to use many light stones (small, incremental rate changes) rather than a few heavy ones.
While the biggest impact from changing the federal funds rate is on other interest rates – including bond yields – its indirect effects on the rest of the economy tend to be more muted and unclear.
Casting Stones
When the Fed raises rates, the cost of borrowing rises, which may impede business growth, decrease consumer spending and contribute to slower economic growth.
For investors, a higher-rate environment also makes fixed-income assets (bonds) more appealing and may also curb demand for equities.
Lower rates, on the other hand, imply cheaper borrowing, greater consumer spending, less demand for fixed-income assets and the overall stimulation of economic growth.
Or at least that’s the theory.
In reality, there’s no guarantee that the Fed’s policy will work the way it’s supposed to on the economy at large. But we can clearly see its effect on one market in particular… bonds.
Short-Term and Long-Term Bonds React Differently
As Rob says in today’s Market Wake-Up Call, changes to the federal funds rate have the biggest and most direct effect on short-term bonds.
Just take a look at two-year and 10-year Treasury bonds versus the federal funds rate.
As you can see, the 10-year Treasury yield is almost completely independent from the federal funds rate. But the two-year Treasury yield moves in near tandem with the federal funds rate.
That’s why Rob suggests looking to long-term bonds to hedge against any rate cuts by the Fed.
He doesn’t think that’s going to happen anytime soon, though…
To find out why, and to learn more about our brand-new Bond Strategist, tune in to today’s Market Wake-Up Call.
Enjoy your Sunday,
Anthony