Interest Rates Down, Bonds Also Down
Have you ever thought of something as the truth only to find out later that it isn’t so?
Many investors commonly believe that when interest rates fall, bond prices should rise, leading to capital appreciation.
While this is true in a textbook, ceteris paribus kind of way, the real world is a lot more complex.
The past year has seen a see-saw of yield movements on the expectation of interest rate cuts and then reversal as interest rate cuts fail to materialise. (The 10-Year treasury here is used as an example, but the same relationship has played out similarly across the 2-Year, 5-Year and 30-Year treasuries)
Finally, on 18th September 2024, the Federal Open Market Committee (FOMC) cut the discount rate by 0.50%.
How did the 10-Year Treasury react?
It fell in price.
The yield on 10-year treasury notes climbed from 3.7% on the day of the interest rate cut to 4.02% (16 October 2024.)
If you are investing in bonds with the anticipation that further interest rate cuts will lead to profits, be aware that the path forward is not a slam-dunk sure-bet. Since 1970, the price of the 10-Year treasury has declined 50% of the time one year later from the first interest rate cut. Essentially, it’s a coin flip.
The reality is that fixed income markets are forward looking and expectations of future interest rates are only one determinant that goes into prices. Economic growth and inflation expectation also affect prices, amongst other factors.
Fixed income is an important component of a well-designed portfolio in managing volatility and acting as a ballast during periods of market downturns. We do not need to trade bonds based on unreliable interest rate forecasts to drive returns.
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