I recently had a discussion with an experienced financial advisor about the bond markets. He believed that bonds would sell off when the U.S. Federal Reserve raised the fed funds rate at the next meeting, which was widely anticipated. He thought that when the Fed raised the fed funds rate, yields across the yield curve would also rise, pushing bond prices lower. I told him that’s not how the bond markets work. Like equity markets, bond investors attempt to try to forecast the future and buy/sell bonds accordingly. I told him I believed the bond markets had already priced in an anticipated rate hike and bonds could remain stable or rally if the bond markets believed the economy would slow from higher rate hikes.
All else equal, the Fed controls the very short-term overnight interest rate banks led to each other, called the fed funds rate. Bonds/bond yields farther out along the yield curve (over different bond maturities) and different than the fed funds rate (Treasury yields, corporate bond yields, etc.) are heavily driven by market supply and demand.
For simplicity, let’s think about what drives U.S. Treasury yields: probability of default over a length of maturity + future inflation expectations. From a default perspective, the probability is low that the U.S. will default on its bonds. So that leaves future inflation expectations that drive the yield on U.S. Treasuries. Right now, inflation is high, over 9% (based on CPI data). U.S. 10-year Treasury yields are around 2.8%. This indicates that bond market investors are only demanding 2.8% yields each year for the next 10 years. This also indicates that bond investors do not believe that inflation (a key driver of Treasury yields) will be 9% over the next 10 years, and that inflation may be closer to the 2.5-3% range on average.
Back to the story about the financial advisor. The U.S Federal Reserve recently raised the fed funds rate 75 basis points (0.75%) to a target of 2.25-2.50% as widely anticipated. Rather than bond yields moving up across the yield curve 75 basis points, like the advisor indicated he believed, bond yields across the yield curve declined and bonds rallied. This was the opposite of what the financial advisor thought. Again, bond markets already thought there was a high probability of the Fed raising the fed funds rate, so that was already priced into the bond markets.
Bond investors may have taken the Fed’s rate hike as a sign of its stance that they were going to be aggressive on fighting inflation, including slowing the economy down. If the economy slows down, inflation could slow down, bringing future inflation expectations down, resulting in bringing U.S. Treasury yields across the yield curve down.
Inverted Yield Curve
The next time you hear someone talk about an inverted yield curve, what they are talking about is a higher short-term rate (fed funds rate) than longer-term rates along the maturity spectrum/yield curve (5-yr, 10-yr, etc. Treasuries). Example: If the fed funds rate is 3% and the 10-year Treasury is at 2.5%, that is an inverted yield curve.
In “normal” times, the yield curve is positively sloping. This is generally when the fed funds rate is lower than longer-term rates. Example: If the fed funds rate is 2% and the 10-year treasury is at 2.5%, the yield curve is positively sloping. In a normal environment, the economy is growing at its “normal” growth rate, the fed funds rate is stable, and investors seek higher returns for Treasuries over a longer period of time.
Investors will talk about an inverted yield curve as a pre-cursor to a recession. Why? Because the bond markets believe the higher short-term interest rates driven by the Federal Reserve raising the fed funds rate to bring down inflation will slow the economy down, bringing a higher probability of recession in the future. We are currently in an inverted yield curve environment right now.
Summary
So the Federal Reserve raised the fed funds rate and bond yields declined. This is a key lesson that whatever the Fed does to the fed funds rate (an overnight rate) may have little to do to longer-term rates that are drive by bond market investors and supply/demand dynamics. The next time the Fed raises/lowers the fed funds rate, don’t be surprised if longer-term rates act differently before the Fed actually does anything. Bond market investors are forward looking. Remember that.