Why the Bond Market Is in the News and What It Means for Your Wallet

Over the past few months, you have likely been bombarded with news articles and pundits talking about the bond market. You've seen articles about the Federal Reserve fighting inflation and the US Treasury trying to push long-term bond yields lower. In this month's blog, we try to break down why rates are so volatile and what it means for your portfolio and wallet.

The Federal Reserve of the United States was founded in 1913 when President Woodrow Wilson signed the Federal Reserve Act into law, creating our country's first central bank. The Federal Reserve was created in response to a very violent and volatile banking crisis known as the Panic of 1907. This crisis caused the collapse of many smaller regional banks that at the time were critical to providing financing and banking to Americans across the country. In response, banks shut down and were unable to provide liquidity to customers looking to withdraw funds from savings accounts.

If you remember the bank run scene in "It's a Wonderful Life," George Bailey said:

"You're thinking of this place all wrong, as if I had the money back in a safe. The money's not here. Well, your money's in Joe's house—that's right next to yours—and in the Kennedy house and Mrs. Maklin's house and a hundred others. You're lending them the money to build and then they're gonna pay it back to you as best they can."

Basically, George was explaining that when someone puts funds in a savings account, the bank uses a portion of that money to lend to another customer for a mortgage or business loan. This means these banks that were supposed to have liquid funds in a vault didn't have them when customers looked to withdraw their funds (aka a bank run).

The Panic of 1907 was ultimately quelled by financier J.P. Morgan, who provided short-term loans to these small banks during the crisis. Following these events, the federal government realized that the country shouldn't have to rely on a private businessman providing bailouts to the economy. It had to act. Thus, the Federal Reserve was created as the "bank of last resort" to respond to future liquidity crises.

Since its creation in 1913, the Federal Reserve has come to look VERY different from its original founding. Its powers and tools have expanded, and it now carries two main objectives: keeping inflation moderate and maintaining full and reasonable employment. One of its main tools is adjusting the federal funds rate, which in short is a short-term borrowing rate for commercial banks taking overnight loans to meet short-term financial obligations. (Think back to our George Bailey quote — the movie would've looked MUCH different if George could've called the Federal Reserve for a quick overnight loan for his customers).

The federal funds rate has a cascading effect on loans down the line. As the Fed raises and lowers interest rates, that shift affects what you earn on bond yields, the rate you get on your car loan, your mortgage rate, student loans, and more.

There was a lot of uncertainty in the bond market in August as we dealt with two competing issues: inflation is not moving toward the Fed's 2% target (the Fed deals with this), and Congress and the federal government are not addressing the federal deficit (investors deal with this).

To move inflation lower, the Federal Reserve may need to increase the federal funds rate, which will make borrowing harder. Think of that new car you were about to buy. If financing went from 2% to 6%, would you still look to buy it? The Fed is betting that a lot of people won't, which will slow the economy down and thus may slow inflation. This has been the story for the past six months and, quite honestly, is the least interesting part of the rates issue.

The most interesting event that happened in August was when the Treasury Department took action to try to lower rates on 30-year Treasury bonds. Remember, Treasury bills, bonds, and notes are financial obligations the federal government owes to a lender. The rate is set by supply and demand. The federal government wants to suppress rates because it wants to borrow at lower rates to fund its projects, salaries, etc. Investors want higher rates to increase returns on their loans. They need to meet in the middle.

Recently, investors have been seeking higher rates on longer-term bonds (30-year Treasuries) because they fear Congress is not doing enough to rein in the deficit and the Federal Reserve is helping to fund it without any recourse. So, investors want to be paid more because they think inflation will be higher in the long run and want to be paid for that risk. The Treasury tried to intervene in that supply-and-demand relationship by buying 30-year Treasuries, essentially reducing the supply while keeping demand the same. The result: the bond market fired back with a vengeance, driving 30-year Treasury yields to their highest levels since 2010.

So where do we go from here?

Our thoughts/views:

• There is an old Wall Street adage: "Don't fight the Fed." But who wins when the Fed and the Treasury are at odds?
• Stocks are generally a long-term inflation hedge, while bonds generally do not perform well during bouts of inflation. In the short term, both can underperform (think investment returns in 2022). If inflation rates rise, we are bullish on commodities and some alternative-type investments. We believe these should be added to portfolios, but we are not abandoning our long-term strategic views on stocks and bonds.
• We do not believe bonds should be abandoned in a portfolio and are comfortable with the asymmetric risk-return payoffs in either a rising or falling rate environment.

  *This blog does not constitute a recommendation or call to action for clients. The purpose of this blog is to provide our thoughts on the markets, the economy, etc. If you have any questions regarding this article, please feel free to reach out.