Why Are Treasury Bonds Falling Despite Rate Cuts?
Decoding the Recent Trends in Treasury Bonds Amidst Monetary Policy Changes
Bonds are underperforming once again. With rate cuts, one would expect Treasury bonds to be on a strong rebound. However, the opposite seems to be happening leaving many investors puzzled.
What is happening?
In this deep dive, we’ll dive into the dynamics of bond yields and prices, the usual relationship between interest rates and bond prices, and the current market conditions that are driving this unexpected trend.
The Correlation Between Interest Rates and Bond Prices
To grasp why Treasury bonds are dropping in price, it is essential to understand the fundamental relationship between interest rates and bond prices. Interest rates play a critical role in determining bond prices. Generally, when the Federal Reserve cuts interest rates, it makes borrowing cheaper and encourages spending. This environment typically leads to an increase in bond prices because existing bonds with higher fixed interest rates become more attractive compared to new bonds issued at lower rates.
For instance, if the Fed lowers rates from 3% to 2%, existing bonds paying 3% will see their prices rise as investors seek to lock in those higher yields. This relationship is foundational in bond investing; however, recent events have introduced complexities.
Two Rate Cuts So Far in 2024
Over the past few years, interest rates have remained high due to persistent inflation pressures that surged to a 40-year peak during the pandemic. As inflation began to stabilize, the Fed initiated a series of rate cuts. In 2024, the Fed has implemented two notable reductions in its benchmark interest rate, signaling a significant shift in its monetary policy.
The first cut took place in September, where the Fed lowered the federal funds rate by 50 basis points, bringing it down to a range of 4.75% to 5%. This marked the first decrease in borrowing costs since March 2020. Following this, on November 7, the Fed announced a second cut of 25 basis points, further reducing the rate to a range of 4.5% to 4.75%. This decision reflects a cautious approach as inflation has shown signs of cooling, currently hovering just above the Fed's target of 2%
So Why Are Bond Prices Underperforming?
Given the ongoing rate cuts, one might expect this to be positive for bonds. However, the current situation tells a different story. The relationship between interest rates and bond prices is not as straightforward as it seems; expectations about future economic conditions significantly influence bond market dynamics.
For instance, the recent decline in Treasury bonds, exemplified by the TLT ETF, is largely attributed to renewed concerns about inflation. Although inflation has decreased considerably from its peak, recent economic data has shown persistent inflationary pressures. Notably, the Consumer Price Index (CPI) rose by 0.2% in October, pushing the annual inflation rate up to 2.6%.
These developments have altered market expectations regarding the speed of future rate cuts.
Uncertainty on Trump Policies
Likewise, President-elect Donald Trump made several promises on the campaign trail, including tariffs on China and Mexico. Tariffs can lead to higher inflation, as they increase the cost of imported goods.
Opportunity Cost and Capital Rotation
Another aspect of bond pricing is the opportunity cost of investing in bonds versus riskier assets like stocks and cryptocurrencies, which tend to perform well in a rate cut environment. The rotation of capital into these opportunities also partly explains why bonds are dropping. For instance, Bitcoin has hit a new all-time high, edging closer to $100,000.
Should You Invest in Bonds?
While bonds have pulled back quite a bit, the decision to invest in them is not straightforward and depends heavily on your risk tolerance and reward expectations. Although interest rates are expected to gradually come down, potential trade tariffs under President-elect Donald Trump could cause the Fed to pause rate cuts due to fears of rising inflation, making bonds less attractive.
Additionally, a rate cut scenario may not be entirely positive for bonds. As rates decrease, investors often rotate into equities and other riskier assets seeking higher returns in a bullish market, rather than betting on bonds.