Why Are Bonds Defying Expectations?

Question: I'm confused. I thought bond prices were supposed to fall after the Fed raises rates. Why are they gaining?

Answer: What is going on in the bond market right now is probably a confluence of several factors. First things first: On March 15, in a move that was widely anticipated, the Federal Reserve Open Market Committee raised its target interest rate a quarter point, to a range of 75-100 basis points.

In the one-month period after the rate hike, the Bloomberg Barclays U.S. Aggregate Index has gained 2.3%. That seems counterintuitive to many investors who understand the relationship between interest rates and bond prices--when rates go up, bond yields rise. Bond yields have an inverse relationship with bond prices, so prices fall. Rising rates are bad for bonds. Right?

Eric Jacobson, a senior analyst on Morningstar's manager research team focusing on fixed income, explored the relationship between interest rate hikes and bond category returns in this article. He points out that while short-term market rates are most heavily influenced by the Fed, how longer-term bonds react to rate hikes depends on a variety of factors--including investors' perception of whether the Fed's is acting too slowly or too quickly.

What's Going on Now? For the one-month period ended April 13, the short-term bond Morningstar Category rose 0.70% and the intermediate-term bond category gained 2.1%. Here's a closer look at what happened to yields in the Treasury market from March 14 (one day before the Fed raised rates) through last Thursday.

It's hard to pinpoint the exact cause, but there are a number of factors at work that have played into the stability of bond returns. By the time the Federal Reserve hiked rates in March, the markets had widely priced in the move and, as a result, the reaction was relatively muted, explains Sarah Bush, director of fixed-income manager research.

Another factor that has influenced bonds lately--on the shorter end of the curve anyway--has been the increased likelihood that the Fed might raise interest rates only twice, rather than three times, in the remainder of 2017. In other words, the Fed will continue to raise rates, as they said they would--only not as aggressively as some had anticipated.

The Fed "dot plots," which are so named because of the dots that make up the target range of the federal funds rate, seen here on Page 3, shows the expectations that each member of the FMOC has for the target fed funds rate through the end of the year and over the next several years. It can give a sense of how many rate hikes might be coming in the remainder of 2017. In the most recent release, the dot plots show the median member anticipating a range of 1.25% to 1.5% by the end of the year, implying only two more quarter-point rate hikes in 2017. That outlook was little changed from the December dot-plot outlook, but many market participants had been anticipating a high likelihood of a more hawkish stance on rate increases. Instead, it looks like the Fed is sticking with its gradual pace of increases to get to a long-run level of 3%, at least for now.

As for factors that could be at play in the longer parts of the curve, U.S. investors have experienced a lot of economic uncertainty postelection, ranging from what healthcare policies will look like to the likelihood that the Trump administration will be able to deliver on promised infrastructure improvements. Geopolitical fears have also increased with recent military strikes in Syria and Afghanistan. Further, questions remain as to what global trade and fiscal policies will look like under the Trump administration.

Another reason is that, even if Treasuries might look anemic to a U.S. investor, low interest rates on global developed debt help keep them anchored.

What Does This Mean Going Forward? I wouldn't take the current rise in bond prices to mean that bonds are immune from feeling any interest-rate-related pain. It's likely that at some point, bonds will lose steam. For instance, the market is currently not expecting the Fed to raise rates at its May 3 meeting; the CME FedWatch Tool currently shows a market-implied probability of over 95% that the Fed will stand pat at 0.75% to 1.00%. If the Fed makes the unexpected move to raise rates at its May meeting, we could see a more dramatic movement in bond prices.

Increased inflation, whether real or anticipated, might also have a big impact on bond prices.

It's hard to time markets; it's much easier to build an asset allocation that makes sense and to stick with it. Instead of focusing on where bond prices may go in the short term, it could pay to take stock of why you're holding bonds in the first place.

"Many people hold bonds because they're looking for protection in case there's a big sell-off in the equity markets. And typically, high-quality bond funds do pretty well during sell-offs," Bush said. "If you're holding bonds for long-term diversification, it's probably best to keep some of those funds with some interest-rate sensitivity because those are the ones that are going to do relatively well to kind of offset the volatility from the equity part of your portfolio."