How the Federal Reserve Reducing Interest Rates Will Affect the Bond Market & Investors
The Federal Reserve Board, or the Fed, sets monetary policy by buying and selling U.S. Treasury and federal agency securities. These operations set the federal funds rate, the rate at which financial institutions lend funds to one another overnight. A change in monetary policy, such as a rate reduction, leads to changes in loan, mortgage and credit card rates. It also affects the markets, and therefore investors who invest in stocks and bonds directly or through mutual funds.
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Facts
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The bond market is where debt instruments, such as U.S. Treasury bills and corporate bonds, are traded. Company shares are traded on stock markets, such as the New York Stock Exchange or NASDAQ. A market index, such as the Dow Jones Industrial Average, measures the performance of a basket of stocks. Monetary policy changes influence several economic indicators, including unemployment, consumer confidence, and the direction of the bond and stock markets.
Bond Market Impact
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The St. Louis Fed charts (see Resource section) show the relationship between the federal funds rate and government and corporate bond rates. Corporate bonds are rated by credit ratings agencies, such as Moody's and Standard and Poor's, based on their relative risk. For example, AAA-rated bonds are considered safer investments than BAA-rated bonds. The charts show that both government and corporate bond rates track the federal funds rate reasonably closely. Bond prices move in an opposite direction to the federal funds rate, meaning a reduction in rate leads to higher bond prices. Therefore, the bond component of an investor portfolio is likely to rise in value when the Fed reduces interest rates. However, lower-grade corporate bonds, such as BAA bonds, may behave differently in a period of uncertainty. During the 2008 financial crisis, for example, their prices dropped because investors demanded a higher risk premium due to the uncertainty over the ability of some companies to pay their bondholders.
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Investor Impact
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Investors are affected because they invest in stocks and bonds, either directly in their online brokerage accounts, or through mutual funds. With respect to the equity markets, from 1970 to 2007, the S&P 500 -- a market index of 500 leading companies -- rose "by an average of 5.5 percent in the three months after the Fed's first rate cut" and "only twice in the nine instances did stocks lose ground." This is according to research done by Chris Ciovacco, chief investment officer of money management firm Ciovacco Capital Management. The 2008 financial crisis, which falls outside Ciovacco's research, saw a near 40 percent drop in the Dow even though the Fed reduced rates to almost zero to deal with the crisis. However, stocks did recover -- by early February 2011, the Dow had gained almost 80 percent from its early March 2009 lows.
Consideration: Rate Increases
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The charts in the Resource section show that rate increases by the Fed almost always lead to increases in Treasury and corporate bond rates. The correlation between rate increases and stock market behavior is less obvious, at least according to the Forecast Chart graph of data from 2000 to 2010.
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References
Resources
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