A popular argument we’ve heard is “if the Federal Reserve only controls the Fed Funds rate, then raising rates doesn’t mean much for the rest of the market.” While this is true, investors generally use that as a floor. The Fed has kept interest rates low by buying Treasury bonds. Investors feel that if a 10-year Treasury yields 2.41%, then a corporate bond has to yield more. Likewise, a junk bond must yield significantly more than that. The spread is increasing between junk bonds and Treasury bonds because people are recognizing the risk involved.
Bond prices and interest rates correlate to supply and demand. Just because the Fed has raised the Fed Funds rate doesn’t mean the three-, five- and 10-year bond yields will increase. The same phenomenon happened during Alan Greenspan’s tenure at the Fed. Eventually, as the Fed increases interest rates, it will reflect in Treasurys at some point.
We also read about an economist who felt because of the supply of commercial debt and Treasury bonds coming to market will meet demand that interest rates will go nowhere for nearly 10 years. We are certainly glad he is able to predict the economy with such certainty. There are two main reasons people borrow money: To expand and grow their business and to cover their losses. We believe it is impossible to predict the market for 10 years. There are too many exogenous variables. International influence alone is unpredictable. China put a hold on buying U.S. Treasurys for several months. Even this week alone, news broke the eurozone was close to a recession.
With the Fed having tapered quantitative easing by half, and interest rates remaining low, someone must be buying Treasury bonds. With geopolitical turmoil, investors flock to safety, which in this case comes by way of U.S. Treasury bonds. When our interest rates rise, emerging markets will suffer. With our higher rates, riskier markets will look less appealing.
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