What happens to bonds when the Fed cuts rates?
Bond Prices and the Fed
A rate cut by the Fed is a boost to the equity market as lower interest rates mean cheaper borrowing for businesses which helps them to expand their operations more easily, ultimately leading to increased profitability.
Why interest rates affect bonds. Bond prices have an inverse relationship with interest rates. This means that when interest rates go up, bond prices go down and when interest rates go down, bond prices go up.
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.
A fundamental principle of bond investing is that market interest rates and bond prices generally move in opposite directions. When market interest rates rise, prices of fixed-rate bonds fall. this phenomenon is known as interest rate risk.
By selling securities, the Fed attempts to raise rates, slow economic growth, and stem inflation.
Since the start of 2024, higher-than-expected inflation data triggered caution from top Federal Reserve officials. The Fed is determined not to reduce interest rates too soon, experts say — a mistake the central bank has made in the past.
While higher interest rates may benefit banks by allowing them to charge more for loans, higher borrowing costs put a damper on transactions, McGratty said. A cut in interest rates may stimulate more economic activity, which will benefit banks, he said.
After its December 2023 meeting, the Federal Open Market Committee (FOMC) predicted making three quarter-point cuts by the end of 2024 to lower the federal funds rate to 4.6%.
Investing in bonds when interest rates have peaked can yield higher returns. However, rising interest rates reward bond investors who reinvest their principal over time. It's hard to time the bond market. If your goal for investing in bonds is to reduce portfolio risk and volatility, it's best not to wait.
Will bond funds recover?
We expect bond yields to decline in line with falling inflation and slower economic growth, but uncertainty about the Federal Reserve's policy moves will likely be a source of volatility. Nonetheless, we are optimistic that fixed income will deliver positive returns in 2024.
As inflation finally seems to be coming under control, and growth is slowing as the global economy feels the full impact of higher interest rates, 2024 could be a compelling year for bonds.
After bonds are initially issued, their worth will fluctuate like a stock's would. If you're holding the bond to maturity, the fluctuations won't matter—your interest payments and face value won't change.
Banks tend to keep only enough cash in the vault to meet their anticipated transaction needs. Very small banks may only keep $50,000 or less on hand, while larger banks might keep as much as $200,000 or more available for transactions. This surprises many people who assume bank vaults are always full of cash.
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.
The share prices of exchange-traded funds (ETFs) that invest in bonds typically go lower when interest rates rise. When market interest rates rise, the fixed rate paid by existing bonds becomes less attractive, sinking these bonds' prices.
| Face Value | Purchase Amount | 30-Year Value (Purchased May 1990) |
|---|---|---|
| $50 Bond | $100 | $207.36 |
| $100 Bond | $200 | $414.72 |
| $500 Bond | $400 | $1,036.80 |
| $1,000 Bond | $800 | $2,073.60 |
There are two ways to make money on bonds: through interest payments and selling a bond for more than you paid. With most bonds, you'll get regular interest payments while you hold the bond. Most bonds have a fixed interest rate. Or, a fee you get to lend it.…
As mentioned earlier, during a recession the Fed usually buys short-term government bonds, which has the effect of driving down short-term interest rates. The Fed usually targets a certain level of the “federal funds rate,” the interest rate that banks charge each other on very short-term (overnight) loans.
Buying inflation bonds, or I Bonds, is an attractive option for investors looking for a direct hedge against inflation. These Treasury bonds earn monthly interest that combines a fixed rate and the rate of inflation, which is adjusted twice a year. So, yields go up as inflation goes up.
Does inflation hurt 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.
In 2025, the median fed funds rate projection falls to 3.75-4.00%, which implies another 75 basis points worth of cuts in 2025.
The median estimate for the fed-funds rate target range at the end of 2025 moved to 3.75% to 4%, from 3.5% to 3.75% in December. For the end of 2026, the median dot now shows a target range of 3% to 3.25%, versus 2.75% to 3% three months ago.
Projected Interest Rates in the Next Five Years
ING's interest rate predictions indicate 2024 rates starting at 4%, with subsequent cuts to 3.75% in the second quarter. Then, 3.5% in the third, and 3.25% in the final quarter of 2024. In 2025, ING predicts a further decline to 3%.
How should investors position ahead of an eventual easing? Energy stocks could be a good bet, says Cayla Seder, macro multi-asset strategist with State Street Global Markets. Big oil producers are likely to benefit if the dollar weakens as the Fed lowers rates since that should lift crude prices.
