Doug Drabik discusses fixed income market conditions and offers insight for bond investors.
The bond market has been very responsive to economic views concerning inflation. The Federal Reserve (Fed) has been very attentive to inflation as they continue to declare, with persistence, a policy geared to achieving a 2% core Personal Consumption Expenditure (PCE) level. If the Fed views inflation as being under control and progressing toward its goal, it will be incentivized to combat any economic activity slowdown by cutting interest rates. When the Fed cuts interest rates, they are lowering the Fed Funds rate. Fed Funds are reserves held in the Federal Reserve account – typically bank overnight funds. The Federal Reserve policy can set the tone that drives interest rates across the maturity range but an earlier market rate downturn can occur as a signal of investor perception of a slowdown in the economy. An aggressive move by the Fed likely shifts the entire range of yields, albeit not necessarily in parallel fashion.
The graphs depict the 10-year Treasury rate in relationship to the Fed Funds rate before and after the last two policy cuts in 2007 and 2019. History reflects that longer-term rates begin to fall before the actual Fed cut. In these two cases, interest rates started falling four and five months prior to the Fed’s move.
The message is simple but important. Most portfolios benefit from a balance of growth and wealth preservation assets, regardless of the interest rate environment. Individual bonds provide a means to preserve capital largely because of their unique characteristic of a stated maturity. Face values are returned to investors, barring a default and regardless of interim rate fluctuations during an investor’s holding period. With interest rates at levels not consistently seen in nearly 17 years, investors benefit from capital preservation and reap the value of elevated income associated with this rate environment.
