There have been quite a few spikes in the news over the last month. From the Badgers’ women volleyball players capturing the national championship to the spike in COVID cases to the Omicron variant’s more effective spikes.
However, no spike has caught our attention more in the new year than the spike in interest rates. Below is a spike summary for U.S. Treasury debt from December 31, 2021, through January 10, 2022:
|Term||12/31/2021 rate||1/10/2022 rate||% change|
Source: U.S. Department of the Treasury
For the typically boring bond market, this spike in rates over a mere six trading days reflects extreme volatility.
What is driving traders’ demand for higher returns and, therefore, causing bond prices to fall? A refocusing Federal Reserve.
Ever since the government shut down the economy in spring 2020, the Federal Reserve’s only focus has been to encourage economic recovery and full employment. Until recently they had dismissed rising inflation as a passing phenomenon created by temporary supply chain issues.
Over the last two weeks it has become quite clear that the Federal Reserve is now fully focused on taming persistent inflationary forces that have far exceeded their expectations. Historically, their primary tool for doing this is raising their overnight lending rate to make borrowing more expensive – reducing the demand for money.
Just three months ago, bond traders only expected the Federal Reserve to raise their target interest rate once in 2022. Today, bond traders are pricing in four rate hikes in 2022 – March, June, September, and December. (Source: CME FedWatch Tool)
Please keep in mind that traders’ change their minds very frequently. Additionally, when bond yields move this far this fast bond traders sometimes start second guessing themselves and rates can dig the spike by retracing their volatile path in future months.
Over the last two years we have been preparing our client portfolios for an eventual rise in interest rates by underallocating to bonds that are more sensitive to higher interest rates. However, we continue include some interest rate sensitive bonds in more conservative portfolios to serve as a cushion against stock market volatility.
While rising interest rates do not surprise us at this point in the economic cycle, the speed of this year’s rate spike has been surprisingly quick. As always, the key to long-term successful investing is not overreacting to short-term market fluctuations whether in the stock market or the bond market.
Quote of the week: Jim Masturzo: “Volatility should not be confused with risk. The permanent loss of capital, which happens when investors succumb to fearful thoughts and thus sell at inopportune times, is the investor’s true risk.”