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Interest Rates, Inflation, and Bonds....Oh MY!

April 05, 2024

Interest Rates, Inflation, and Bonds... Oh MY!

How does the Federal Reserve Impact the Bond Market?

In the current year, the main topic around the markets is inflation and the current outlook on the Federal Reserve’s monetary policy, specifically associated with their decisions on interest rates. It is a common misconception that the Federal Reserve (the Fed) controls the interest rates for the whole bond market, but that is not the case. The Fed only controls one rate- the Federal Funds Rate. This is a short-term rate which banks use when lending each other money in order to satisfy their cash reserves. It is an important tool used by the government to influence the economy. As the rate increases, it gets more expensive for banks to borrow money, which is then passed on to consumers. With a higher cost of borrowing, the economy, in theory, slows down. Same is true, vis versa.

However, it is very important to understand that the Federal Reserve has an indirect impact on debt that trickles down from the banks to businesses and consumers alike. Therefore, not all debt will have a substantial reaction to the changes made by the Federal Reserve.  For example, mortgage rates are influenced by many other factors, other than just the Federal Funds Rate, such as the overall mortgage-backed investment market, consumer demand, gross domestic production, and inflation. Although all of these are interconnected, the factors can still vary and cause changes beyond what the Fed is doing. Therefore, mortgage rates won’t go down just because the Fed lowers their rates.

What is Happening to the Federal Funds Rates Today?

In April 2024, the current Federal Funds Rate is set at 5.25-5.50%, after multiple rate hikes throughout 2022 and 2023 due to the historical rise in inflation following the Covid-19 pandemic. These rates have remained steady for the past five Fed meetings, including the last meeting in March. Most analysts believe that the current rate is too high for the long term and rates will drop down. The most important question is when this will occur. There is some indication that rates might drop by fall 2024, others that say it won’t happen until closer to year end or into 2025. When this does occur, again, it doesn’t mean that rates will drop instantly or concurrently for all types of debts, but it will impact them all to a degree. So, what does this mean for investors? How can an investor prepare their portfolio for this market shift?

What Happens to Bonds when Interest Rates Fall?

Looking at existing bonds, there is an inverse relationship between interest rates and bond prices. Meaning, when rates fall, bond prices rise. This is because existing bonds will be able to earn more than new bonds. For example, a $100 bond with a 4% coupon could be traded at $105 in a market where a new bond only has a 3% coupon. But, again, not all bonds will have a significant change in interest rate or bond pricing based on what the Federal Reserve is doing. There are many factors to consider, such as callability, credit rating, bond type, and duration. Perhaps the most significant of these factors being duration. 

Duration measures how long it takes, in years, for an investor to be repaid a bond’s price by the bond’s total cash flows. Both maturity and the coupon rate influence this measurement. Additionally, the duration of the bond increases its sensitivity to interest rate changes. The higher the duration of the bond, the more sensitive it is to changes made, because usually that bond is locked in for a longer period of time. Generally, bonds with long maturities and/or low coupons have the longest durations. Therefore, these bonds will rise the most when interest rates fall. At the same time, it is important to note that if rates decrease or remain steady for longer than anticipated, these bonds will lose more than other bonds. As such, it is important to still maintain diverse holdings to protect bond assets from that risk.

Additionally, duration is just one of the many factors that impact bond sensitivity. Investors have to look at all aspects of the bond that will impact how quickly and how much a bond price might move when interest rates are inevitably lowered. It is important to consult a financial expert to fully understand the risk and impact on your own personal portfolio. Please, reach out to afanning@g5financialgroup.com for a full analysis and help to determine what fixed assets fit into your portfolio.

 

Sources:
Duration Definition and Its Use in Fixed Income Investing (investopedia.com)
The Most Important Factors Affecting Mortgage Rates (investopedia.com)
Federal funds rate: Current rate and historical changes | CNN Underscored Money