How Changing Interest Rates Affect Bonds | U.S. Bank (2024)


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How Changing Interest Rates Affect Bonds | U.S. Bank (1)

Key takeaways

  • U.S. Treasury yields have trended higher in 2024.

  • Yields on the benchmark 10-year U.S. Treasury started the year below 4%, but in early April moved above 4.5%.

  • Bonds in the current environment appear to offer investors more attractive long-term opportunities.

With the timing of anticipated Federal Reserve (Fed) interest rate cuts in question, bond yields trended higher – within a modest range – for much of the year. In early April, yields on the benchmark 10-year U.S. Treasury note jumped up, moving 0.2% higher in a single day.

“Economic growth remains solid, which might indicate interest rates need to remain elevated for some time,” says Rob Haworth, senior investment strategy director for U.S. Bank Wealth Management. “The most recent data indicates inflation may linger higher for longer, and we’re also seeing foreign buyers stepping back from the U.S. market. Both factors contribute to keeping bond yields higher as well.”

The yield on the 10-year U.S. Treasury started the year at 3.88%, but moved to 4.55% in early April.1 The latest jump occurred in the wake of a government report showing that inflation, for the 12-month period ending in March 2024, rose to 3.5%, its highest level since September 2023.2 After topping out at 4.98% in October 2023, 10-year Treasury yields dropped below 4%, but have trended higher over the course of 2024, with modest up-and-down-movements.1

How Changing Interest Rates Affect Bonds | U.S. Bank (2)

The bond market in 2024 continues to exhibit topsy-turvy dynamics, with yields on short-term bonds exceeding those of longer-term bonds. For example, as of April 10, 2024, 3-month Treasury bills yielded 5.45% and 2-year Treasury yields were 4.97%, compared to the 4.55% yield on the 10-year Treasury.1 The Fed is keeping the door open to potential federal funds target rate cuts later in the year, but the latest inflation data may push the timeline for the start of Fed rate cuts further out.

The current bond yield environment emerged after the Fed began raising the short-term interest rate it controls – the federal funds rate – in early 2022. Between March 2022 and July 2023, the Fed raised rates eleven times, from near 0% to an upper range of 5.50%. Since then, the Fed has held the line on further rate hikes and indicated that it will eventually begin cutting rates in 2024, reversing its previous policy.

“If the Fed cuts short-term interest rates, yields on shorter-term debt issues are likely to decline,” says Haworth. “The current upward movement we’ve seen in bond yields reflects markets getting well ahead of expectations for 2024 Fed rate cuts,” says Haworth. At recent meetings of the policy-making Federal Open Market Committee (FOMC), the indication was that three cuts would occur in 2024. “The markets, however, appeared to anticipate many more 2024 rate cuts, and long-term bond yields began to drop in late 2023 as a result.” says Haworth. “Now the reality set in that the Fed is maintaining higher rates for longer than the markets initially anticipated.” That resulted in the recent upward movement in bond yields.

What should investors expect from the bond market for the remainder of the year and what does that say about how to incorporate or adjust strategies for fixed-income investors?

Changing bond market

Despite the recent decline in bond yields, they remain significantly higher than was the case at the start of 2022. “Three key factors drove the jump in bond yields,” says Bill Merz, head of capital markets research at U.S. Bank Wealth Management. “First is the Fed’s policy response to inflation. Second is the strength of the U.S. economy. Finally, there is an increasing supply of U.S. Treasury securities coming to the market.”

“Money sitting in cash loses purchasing power every day that inflation rates stay above zero. Investors with a low tolerance for risk can offset the impact of inflation on their purchasing power, and in the current environment, grow their purchasing power, by owning bonds with a range of maturities,” says Bill Merz, head of capital markets research at U.S. Bank Wealth Management.

“New Treasury bond issuance is growing due to a combination of federal government deficit spending that must be funded and the higher interest costs associated with today’s elevated interest rates,” says Merz. At the same time issuance is up, the Fed, as part of its monetary tightening policy, began allowing its large portfolio of U.S. Treasuries and agency mortgage-backed securities to mature. “That means other investors need to absorb the growing Treasury supply,” says Merz.

Haworth believes the Fed may need to reconsider its policy of reducing its balance sheet of Treasury debt given the federal government’s need to expand Treasury issuance to cover budget shortfalls and other funding priorities. “It may need to hit the brakes on its balance sheet reduction at some point in the future,” says Haworth.

Inverted yield curve persists

The yield curve, representing different bond maturities, has persistently remained inverted since late 2022. Under normal circ*mstances, bonds with longer maturity dates yield more, represented by an upward sloping yield curve (as in the line on the chart representing the yield curve on 12/31/21). It logically reflects that investors normally demand a return premium (reflected in higher yields) for the greater uncertainty inherent in lending money over a longer time. Many yield curve pairs using various maturities have been inverted since late 2022. This is due in large part to the Fed’s rate hikes, which have the greatest direct impact on short-term bond yields.

How Changing Interest Rates Affect Bonds | U.S. Bank (3)

Haworth notes that in recent months, the inverted curve has flattened a bit. “Yields are still higher on one-month to two-year Treasuries, but the curve is relatively flat from the five-year level on up.” Haworth says a major question is how the inverted yield curve scenario is resolved. “If shorter-term yields come down to normalize the curve, it will reflect the Fed achieving its inflation-fighting goals. If the curve normalizes because long-term rates go higher, it likely means inflation remains elevated, which results in other challenges for the Fed and investors.”

Keeping an eye on the Fed

The Fed’s rate hikes were designed to slow the economy as a way to reduce inflation, which peaked at 9.1% for the 12 months ending June 2022, but dropped to 3.1% by January 2024. However, March’s 3.5% inflation raises concerns that the inflation fight is far from over.2

In the meantime, markets are keeping a close eye on the timing of the first Fed rate cut. “When the Fed decides to do so, its focus will be less on stimulating the economy than on gradually loosening its monetary policy to return to a more neutral position,” says Haworth. “But we will need to see a number of rate cuts to reach a “neutral” fed funds rate, which the Fed indicates is 2.5%.” This compares to the current fed funds target rate range of 5.25% to 5.50%.

Finding opportunity in the bond market

How should investors approach fixed income markets today? “Money sitting in cash loses purchasing power every day that inflation rates stay above zero,” says Merz. “Investors with a low tolerance for risk can offset the impact of inflation on their purchasing power, and in the current environment, grow their purchasing power, by owning bonds with a range of maturities.”

Despite the appeal of short-term bonds paying higher yields, Merz says investors with a long-term time horizons are well served by building diversified portfolios designed to generate competitive returns over time. “It’s time to take money that was shifted away from appropriate bond allocations during the period of historically low interest rates to gradually move money into longer-term bonds. Longer-term bond yields remain far more compelling today than they have been in years.” Merz says for conservative investors, “It’s possible to generate reasonably attractive returns in a mix of bonds without extending their risk budget.”

Additional opportunities exist depending on investors’ risk tolerance and tax situation. For example, investors in high tax brackets may benefit from extending durations slightly longer and including an allocation to high-yield municipal bonds as a way to supplement their investment grade municipal bond portfolio. Certain non-taxable investors may benefit from diversifying into non-government agency issued residential mortgage-backed securities. They can also incorporate long-maturity U.S. Treasury securities to manage total portfolio duration. And insurance-linked securities may offer a way to capture differentiated cash flow with low correlation to other portfolio factors for certain eligible investors.

Talk to your wealth professional for more information about how to position your fixed income investments as part of a diversified portfolio.

Frequently asked questions

The bond market is often reflective of other key factors that affect the economy. If the economy grows rapidly and inflation is rising, bond yields tend to follow suit. Bond yields also tend to rise if the Federal Reserve, the nation’s central bank, raises the short-term interest rate it controls, the federal funds rate. Inflation in the U.S. began surging in 2021, and by early 2022, the Federal Reserve began raising rates. As a result, yields across the bond market began rising. In contrast, if the economy is slowing or maintaining modest growth with low inflation, bond yields tend to decline or remain low. This was the situation for an extended period prior to 2022.

Bond prices move in inverse fashion to interest rates, reflecting an important bond investing consideration known as interest rate risk. If bond yields decline, the value of bonds already on the market move higher. If bond yields rise, existing bonds lose value. The change in bond values only relates to a bond’s price on the open market, meaning if the bond is sold before maturity, the seller will obtain a higher or lower price for the bond compared to its face value, depending on current interest rates. Bondholders will generally be repaid the face value of a bond if it is held to maturity, regardless of the interest rate environment.

There are advantages to purchasing bonds after interest rates have risen. Along with generating a larger income stream, such bonds may be subject to less interest rate risk, as there may be a reduced chance of rates moving significantly higher from current levels. However, even when interest rates are low, bonds can still be appropriate for inclusion in a well-diversified portfolio.


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How Changing Interest Rates Affect Bonds | U.S. Bank (2024)


How Changing Interest Rates Affect Bonds | U.S. Bank? ›

Bond prices move in inverse fashion to interest rates, reflecting an important bond investing consideration known as interest rate risk. If bond yields decline, the value of bonds already on the market move higher. If bond yields rise, existing bonds lose value.

How interest rates change affect bonds? ›

When the Fed increases the federal funds rate, the price of existing fixed-rate bonds decreases and the yields on new fixed-rate bonds increases. The opposite happens when interest rates go down: existing fixed-rate bond prices go up and new fixed-rate bond yields decline.

What happens to interest rates when the central bank buys bonds? ›

When the Federal Reserve buys bonds, bond prices go up, which in turn reduces interest rates. Open market purchases increase the money supply, which makes money less valuable and reduces the interest rate in the money market. OMOs involve the purchase or sale of securities, typically government bonds.

Will bank stocks go up when interest rates drop? ›

The lower interest rates signaled by the Fed this week will decrease the cost of borrowing for banks to fund loans and other transactions, KBW banking analyst Chris McGratty noted. This has helped trigger a surge in bank stocks that extended for a second day on Thursday following the Fed's latest meeting.

Will bond funds recover in 2024? ›

As for fixed income, we expect a strong bounce-back year to play out over the course of 2024. When bond yields are high, the income earned is often enough to offset most price fluctuations. In fact, for the 10-year Treasury to deliver a negative return in 2024, the yield would have to rise to 5.3 percent.

Why do banks lose money on bonds when interest rates rise? ›

What causes bond prices to fall? Bond prices move in inverse fashion to interest rates, reflecting an important bond investing consideration known as interest rate risk. If bond yields decline, the value of bonds already on the market move higher. If bond yields rise, existing bonds lose value.

What will happen to bonds if interest rates rise? ›

Bond prices and interest rates have an inverse relationship. When interest rates rise, newly issued bonds offer higher yields, making existing lower-yielding bonds less attractive, which decreases their prices.

Should you buy bonds when interest rates are high? ›

Bottom line. Ultimately, the decision on whether or not to hold bonds and in what amount will depend on the unique circ*mstances of each individual investor. But the rise in interest rates has made bonds more attractive than they've been in over a decade.

What happens when the Fed buys bonds from banks? ›

If the Fed buys bonds in the open market, it increases the money supply in the economy by swapping out bonds in exchange for cash to the general public. Conversely, if the Fed sells bonds, it decreases the money supply by removing cash from the economy in exchange for bonds.

Is now a good time to buy bonds? ›

Answer: Now may be the perfect time to invest in bonds. Yields are at levels you could only dream of 15 years ago, so you'd be locking in substantial, regular income. And, of course, bonds act as a diversifier to your stock portfolio.

Do banks make money in a recession? ›

When economic activity slows down, bank stocks are typically among those hit hardest. That's because banks' earnings are, to varying extents, tied to borrowers' ability to repay their loans, as well as to consumers' and businesses' appetite for more credit.

Will banks do good in 2024? ›

Deloitte expects bank profitability in 2024 to be tested due to higher funding costs and sluggish revenue growth. Banks with diversified revenue streams and strong cost discipline are likely to boost profitability and market valuation.

What is the bank outlook for 2024? ›

Fitch has a 'deteriorating' outlook for U.S. banks in 2024, with continued pressures on the U.S. banking sector, including slow loan growth, elevated funding costs and normalizing credit quality. We expect the economy to meaningfully slow in 2024 but no longer forecast a recession.

Where are bonds headed in 2024? ›

Key central bank rates and bond yields remain high globally and are likely to remain elevated well into 2024 before retreating. Further, the chance of higher policy rates from here is slim; the potential for rates to decline is much higher.

What makes bond prices go up? ›

Essentially, the price of a bond goes up and down depending on the value of the income provided by its coupon payments relative to broader interest rates. If prevailing interest rates increase above the bond's coupon rate, the bond becomes less attractive.

How does inflation affect bonds? ›

The twin factors that mainly affect a bond's price are inflation and changing interest rates. A rise in either interest rates or the inflation rate will tend to cause bond prices to drop. Inflation and interest rates behave similarly to bond yields, moving in the opposite direction from bond prices.


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