Bond Investing 201

Aug 18, 2021
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SMI often refers to "Bond Investing 101" — the rule that when bond yields move in one direction, bond prices always move the other direction. So if rates rise, bond prices fall (and vice versa).

Sometimes we add a follow-up point: the longer the duration (time until maturity) of the bond, the more its price will tend to move in response to a change in interest rates.

Those are great starting points. The first is absolute. The second is usually true.

With a setup like that, you know what’s coming next...this isn’t "usually" and that second point requires a bit more explanation as a result.

Short- and Long-term rates don’t always move together

So consider this Bond Investing 201. We’ll call today’s class "The Difference Between Short- and Long-Term Interest Rates."

Let’s start with the general rule above that the duration of a bond normally determines how much its price reacts to a change in interest rates. The reason this is usually true is that short-term (ST) and long-term (LT) interest rates move in the same direction much of the time. If both ST and LT rates are moving in the same direction, duration is going to be the key determinant of how much the prices move, because they’re all moving in the same direction. LT bonds will move more, but ST bonds will move in the same direction.

Here’s a quick example. Consider the normal historical case where the Federal Reserve Board sees growth in the economy running hot and the risk of inflation rising. So they hike ST interest rates — the only rates directly under their control. We know from our first rule that higher ST rates are going to cause ST bond prices to decline.

In this example, LT rates are likely to also rise in response to the Fed’s rate hike, even though LT rates aren’t directly controlled by the Fed.

The reason is that LT rates are primarily driven by expectations of future economic growth. With growth running hot, expectations of future growth are likely to be strong, so the bump in ST rates will tend to ripple all the way up the yield curve. That doesn’t mean every maturity of bond will increase by the same exact amount — a 0.25% increase by the Fed might translate to a 0.20% increase to the 2-year Treasury bond, an 0.18% increase to the 5-year, a 0.15% increase to the 10-year, etc. But if rates are rising because of strong economic growth (the traditional reason for rate hikes, at least in the past few decades), this would be the normal pattern. The same is true if rates are being cut because of worries that economic growth is slowing — the whole curve tends to move in the same direction.

Why it’s different this time

The key point so far is that ST rates and LT rates are driven by different forces. ST rates are more directly under the control of the Fed and move in response to the Fed changing them. LT rates are set by the market (investors collectively buying and selling) and tend to move in response to expectations of future growth.

Today, the Fed appears to be increasingly coming around to the realization that they’re behind the curve on adjusting ST interest rates to deal with the inflation threat. This realization — and its implications — is what has been driving most of the market action over the past 8-10 weeks (since the mid-June "Fed Flinch"). With ST rates so low and inflation coming in (and staying) high, there’s a mismatch. While the Fed hasn’t hiked rates yet — and probably won’t for a while yet because there are other steps they’ll likely take first, starting with tapering their purchases of financial assets — bond investors aren’t waiting for that first rate hike to act.

When we talk about the yield curve, it’s important to understand that Treasury bonds are issued at multiple intervals along that curve. The Fed directly controls only the Fed Funds rate, which is the shortest rate. Other short-term Treasury bonds — 1-mo, 2-mo, 3-mo, 6-mo, etc. — are heavily influenced by changes to the Fed Funds rate, but also are impacted by market participants being willing to pay more or less for those bonds. So even without a Fed rate hike, bond prices (and by extension their yields) all along the yield curve can react to an expectation that the Fed is closer to a rate hike than was expected.

This is exactly what has been happening at the short end of the yield curve. The 2-year Treasury, for example, went from a yield of 0.14% before the June Fed meeting to 0.28% less than two weeks after it.

However, while ST rates have been rising lately, LT interest rates have been in sharp decline. From a peak of 1.75% in March, the 10-year Treasury yield had fallen below 1.20% in early August. If you’ve been reading my rantings lately you know why: economic growth likely peaked in the second quarter and the rate of growth (while still strong) is declining now. LT yields have been responding to this slowing growth rate story, even as ST yields are moving the opposite direction.

So this is one of those unusual cases where ST and LT rates are reacting to different factors and not trending in the same direction. As a result, the yield curve has been flattening — the gap between ST and LT rates has been getting smaller. (That’s why we exited the IVOL trade a few months ago: IVOL benefits from a widening spread between ST and LT rates.)

To really simplify all this, consider that economic growth expectations and inflation expectations normally move in the same direction. But not always. The 1970s introduced us to an ugly term, "stagflation," referring to stagnant growth but increasing inflation. That appears to be what the bond market’s expectation is today, at least for the immediate future.

Slowing growth and "sticky" inflation may just be a short-term phenomenon that sticks around for a couple of months or a couple of quarters, or it can be a longer-term setup. The good news is SMI’s trend-following strategies are built to handle these types of shifts. Many of our recent moves across multiple strategies have reflected these trends: shifting out of small stocks into large, out of value and into growth, adding Real Estate, and so on. If we’re in for a bout of stagflation, we’ll be ready — and, when the time is right, we’ve got the process to shift us out of that stance too.

Written by

Mark Biller

Mark Biller

Mark Biller is Sound Mind Investing's Executive Editor. His writings on a broad range of financial topics have been featured in a variety of national print and electronic media, and he has appeared as a financial commentator for various national and local radio programs. Mark also serves as Senior Portfolio Manager to SMI Advisory Service’s Private Client managed-account program and the SMI Funds.

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