Particularly in light of last week’s rate increase by the Federal Reserve – the fourth such increase since December 2015 – we want to address a common misperception that the Fed’s actions affect rates across the entire so-called “yield curve” (short, intermediate and long-term rates).
In reality, their actions directly impact short-term rates only, and more specifically, their benchmark federal funds rate, the rate at which banks lend funds held at the Federal Reserve to other banks overnight. Intermediate and longer-term interest rates are driven by a multitude of factors, and, ultimately, market (supply and demand) forces. Such factors include forecasts of future Fed rate increases, based on inflation and economic growth expectations, as well as key foreign lending rates relative to U.S. rates, given investment capital flows are global in scope.
They say a “picture is worth a thousand words” and the chart below is insightful in this regard. It plots weekly interest rates for 1-year, 3-year, 5-year and 10-year US Treasury bills from December 1, 2015 through June 20, 2017. Again, during this time period, the Fed has increased the fed funds rate four times, by 0.25% on each occasion. While you can see that there has been a corresponding increase in short-term 1-year Treasury yields (although still not as much as the cumulative 1% increase in the fed funds rate over the entire time period), increases have been less pronounced for longer-dated Treasuries. Indeed, the yield on 10-year Treasuries has actually declined slightly (from 2.23% to 2.18%).
The moral of the story: Whenever the Fed raises its target for short-term rates, intermediate- and long-term rates may not rise by the same amount. Even more importantly, as far as investing is concerned, predicting bond movements is just as hard as predicting stock movements. Rather, we feel it is prudent, as always, to have a diversified blend of fixed-income maturities, based on your needs/time horizon, rather than what the Fed may or may not do. Finally, while yields remain stubbornly low, don’t lose sight of the critical role bonds and CDs continue to play in a portfolio – namely, providing a source of stability against equity risk/volatility.