Friday, May 31, 2013

Q&A Series – The Bond Market and Interest Rates

This week’s question comes from Stuart, a client who would like more information about the current bond market environment and the recent increase in interest rates.

Q. What is going on with the bond market and why are interest rates going up?

Thanks for your question, Stuart. The bond market is a somewhat complicated animal and there are many reasons why interest rates can move higher. Let’s focus on the 10-year U.S. Treasury yield as it’s one of the most widely followed measures on interest rates. The current yield on 10-Year U.S. debt is 2.1%, which is still very low by historical standards. The big hullabaloo in the news lately is in response to these rates moving higher just over the past few weeks from 1.7% to 2.1%, which is the highest level in a year for the 10-year bond.

When interest rates move higher, the price of the underlying bond moves inversely, and therefore, the value of the bond declines. So, investors in bonds see a decline in their principal as interest rates move higher. All else equal, this is one reason investors would consider avoiding or underweight bonds that would be negatively affected by rising interest rates. Stocks can also be negatively impacted by a sharp increase in rates, especially in the short run. However, the forces pushing interest rates higher are typically positive economic developments, and therefore, will likely have a positive impact on future stock prices.

There are several reasons for interest rates to move higher, some more ominous than others. We think the recent move is likely in response to some of the less sinister reasons. First, there could be some assumption that the Federal Reserve is going to scale back their programs designed to keep interest rates lower. One of the mandates of the Fed is to encourage full employment. According to the government and Gallup poll data, the unemployment rate has steadily moved lower from over 10% just a few years ago to less than 8% currently. As the unemployment rate moves closer to the Fed target of 6.5% you would expect interest rates to rise in anticipation of a less accommodative policy by the Federal Reserve.

Another reason for interest rates to increase is general economic strengthening. Stock prices have reached all-time highs as corporate performance – namely, profits – improve. The housing market is strengthening as new homes are being built at higher annual rates. Moreover, housing prices have increased 10% over the past year compared to a year earlier. The March housing report indicated that this increase in prices was the largest gain for home prices since 2006.

Consumer confidence reached its highest level since 2008, likely because of the improvement in stock prices, the improvement in the housing market, and an improving job market. The current economic conditions do not support the ultra-low interest rate environment you would expect to see during a recession or even a depression.

Finally, interest rates can also increase when inflation is expected to increase. But with industrial capacity utilization still running below the long term average and unemployment still elevated, a surge in inflation doesn’t seem likely for the near term. In fact, the most recent reading of core price inflation shows a current inflation rate coming in at roughly 1%, well below the normal 2% or 3% expectation.

While CNBC and some other media outlets have advertised this move as significant, a longer term review would indicate this recent increase to be a rather slight adjustment (albeit the recent uptick in rates occurred over a relatively short period of a month). We would expect rates to continue to move higher over the next few years especially if the economic data generally continues to improve.

I hope the foregoing has given our readers some useful information regarding the bond market and interest rates. Please contact us if we can provide more guidance and evaluate your particular situation.

We encourage our clients and readers to send us questions for our Q&A series at And as always, we hope you will keep Rollins Financial in mind when seeking professional advice on financial planning and investing.

Best regards,
Eddie Wilcox, CFA

No comments: