How interest rates are shaping up
Joel Dresang: Kyle, we use the yield curve to measure interest rates at different maturities for bonds. It’s a useful tool for investors looking at the fixed-income side of their portfolios. Tell us where we are with the yield curve and what it means for investors.
Kyle Tetting: Joel, that yield curve really can be very indicative of what’s going on in the economy and tell us a lot about our expectations for the future.
What we’ve seen recently, especially in the last couple of years, is the Fed raising the short-term interest rates, the overnight rate, the one they have control over, in order to remove some accommodation from the economy.
The direction of interest rates does influence the underlying price of a bond that you hold. If you buy a bond at a certain interest rate and interest rates go up, it makes the bond you already purchased less valuable.
And so, as we look at the yield curve, and as we’re predicting the direction of the yield curve or trying to understand where things are moving, it will also influence the price of your underlying bonds.
Joel: So, you said the Fed controls the short end of that curve. The long end, though, that’s basically not moved at all. Why is that?
Kyle: Yes. So really, the longer end of the yield curve is all dictated based on expectations for economic growth and expectations for inflation, and as we’ve said for many years now since the recession, the expectation for inflation just still isn’t there. You know, we don’t see the economy really growing out of hand. We don’t see inflation really getting out of hand either, and so investors really aren’t demanding an interest premium to buy bonds that are longer maturity or that aren’t due for a number of years.
Joel: So, that flattening of the yield curve that we’re seeing, what does that mean for investors?
Kyle: You know, I don’t think the flattening so much is the issue. We’d be more concerned if we saw an inversion of the yield curve, where shorter-term rates are paying more interest than longer-term bonds might get. And, we haven’t seen that. We don’t really expect to see that. But there is some concern with flattening that you could get to that point.
I think if we do see inflation come back as an expectation, if we do see the economy continue to improve and grow, you’ll see the longer-term rates start to move higher.
So, I think that’s something we can watch but not something that’s really on the top of the list right now.
Joel: So, as a fixed-income investor, what should I be doing with the yield curve as it is right now?
Kyle: I think bond investors, fixed-income investors, need to remember that they get paid a little bit extra in a normal environment to buy those long-term bonds. That’s worked out very well as the rates on those longer-term bonds have stayed relatively stable. They haven’t faced the headwind of rising rates: As the rates rise, the bond price tends to fall. The volatility of that is more pronounced in long-term bonds.
But at the same time, on the short side of the market, they face the pressure of higher rates, but it’s a less volatile area to be when rates are rising. You get paid a little less to, to take a little bit less volatility.
So there probably is a sweet spot somewhere in the middle where you can avoid some of the volatility of the longer-term bonds, but get a little bit higher interest rate than you do on the shorter-term bonds.
Joel: So then, what are the expectations for the yield curve?
Kyle: Joel, I think the, the most important piece here is not to try to predict whether the long-term rate’s going to move this week or next, not to try and predict whether the short-term interest rates are going to move this week or next.
There’s a lot of variability to that, but the likelihood is that given how low rates are historically, rates are going to move higher.
The good news in all that for investors, especially for balanced investors, is that the stock piece of their portfolio is going to participate in the economic growth that leads to inflation. That doesn’t mean that we should abandon bonds, though.
You have to remember that bonds play a very particular role in a portfolio: Providing that stability, providing that buoyancy so that you can take the risk on the stock side, so that you can participate in growth while you still have a piece that you know can be a bit more safe.
Talking Money: Yield Curve, a Money Talk Video with Kyle Tetting
Strategies for bonds amid rising rates, a Money Talk Video with Marc Amateis
How bonds fared as Fed has raised rates, a Money Talk Video with Kyle Tetting
Tips Before You Invest in Bonds, from the Financial Industry Regulatory Authority
(initially posted February 16, 2018)