End of the hiking cycle
The Federal Reserve implemented an aggressive interest rate policy, leading
to a cumulative increase of 5.00% in the Fed funds rate from March 2022 to
May 2023, aimed at controlling inflation. As we approach the end of the
hiking cycle, the most recent data on inflation indicates a consistent
slowdown for the past ten months. This can be attributed to the delayed
impact of reducing the money supply and raising interest rates, which has
started to affect various inflation indicators. In June 2022, the
year-over-year inflation reached its peak at 9.1%. However, it has since
declined to 4.9%, which is still significantly higher than the Federal
Reserve’s target inflation rate of 2% annually. Despite this, following its
latest meeting, the central bank hinted at a possible pause in rate hikes,
stating that it will closely monitor incoming information and assess its
implications for monetary policy.
What happens to bonds if interest rates drop?
When interest rates fall, bond prices typically rise, and there may be an
opportunity to profit if an investor sells the bond before maturity. For
instance, if rates drop 1%, previously issued bonds are more attractive
than current ones, as debt issuers will take full advantage of the now
lower rates, so investors would be willing to pay a premium — above the par
value — for those bonds. If an investor sells when the bond is trading at a
premium, they can profit from the capital appreciation and the income
earned up to that point on the bond.
Bond’s comeback
Let’s look at the long end of the yield curve or the “TLT” (20+ Year
Treasury Bond ETF); given the incredible drop over the last two years,
bottoming at the -2 standard deviations line, it still looks undervalued,
trading over one standard deviation, below its mean value of 126.
