That yield curve.
While the Federal Reserve recently announced they were holding interest rates steady as of August 1, the stage is set for more increases down the road. After slashing the Fed Funds rate to near zero by the end of 2008 from 4.75% the previous year, the Fed reversed course slowly, starting with one 0.25% increase at the end of 2015. By the end of June, the Fed increased rates six more times, with a forecast of one to two more increases this year. As of June 30, the Fed Funds rate was 2%.
As interest rates rise, investors often believe they should do something about it, but they must first understand an important concept. Often, we talk about interest rates as if there's a single interest rate that applies to all things everywhere. This is far from reality.
Why the Yield Curve Matters
Interest rates are, in fact, different across a range of maturities and together these varying interest rates create a "yield curve." There are different yield curves for different investments, though the most talked about and most referenced is the Treasury yield curve, which is the focus here. The Treasury yield curve is a collection of interest rates on U.S. Treasury bonds across a range of maturities (from 1 month to 30 years). Traditionally, the yield curve is upward sloping, which means interest rates are lower for shorter maturity bonds and higher for longer maturity bonds.
This makes sense as investors should be compensated for lending money to the government for longer periods of time.
Any discussion of "rising rates" in the context of decisions made by the Federal Reserve is specifically targeted at very short-term rates. This is because the Federal Reserve controls the Fed Funds rate-the overnight rate at which banks lend to other banks-but does not control interest rates further along the yield curve. In fact, for longer maturity bonds, market sentiment and inflation expectations play a large role in determining current interest rates. In other words, the Federal Reserve has little to no control over how certain parts of the Treasury yield curve change from day to day.
When the financial press talks about the Federal Reserve raising rates, it's important to remember that they are explicitly referring to short term interest rates-very short-term rates tends to move in tandem with the Fed Funds rate while intermediate- and longer-term rates may or may not. In fact, between December 2015 and June 2018, as the Federal Reserve raised the Fed Funds rate several times (from near zero to 2%), movement along the yield curve was very different-the very short end increased more than the longer end of the curve, causing the yield curve to flatten dramatically.
The yield curve is constantly changing its shape as bond yields (and subsequently prices) move up and down, but the general trend over the last few years has been towards a "flatter" curve. A common measure cited in the bond market is the difference (or spread) between the two-year and the 10-year Treasury rate, the narrower the spread the flatter the curve. At the end of 2015, that spread was 1.21% compared to 0.33% at the end of June.
What does this mean for investors? Predicting how the yield curve may change is a notoriously difficult task. Many professional investors don't even try; they simply keep their portfolio's interest rate sensitivity near that of their benchmark and let security selection and asset allocation decisions drive relative returns.
Investors need to understand the role bonds are meant to play in their portfolios. For many, it's a stabilizing force against equity market declines-Treasury bonds and other highly-rated bonds have historically shown very low or negative correlation to equities. So, while it can be difficult to stick with a bond allocation when most core bond portfolios are losing ground (as we've seen this year), predicating the next recession or stock market crash is impossible. When it happens-and it always does-investors who remained true to their long-term investment goals and allocations will be glad they did.
By: Cara Esser
Cara Esser, CFA is a senior investment research analyst and investment committee member in Mesirow Financial's Retirement Planning and Advisory group.