| The question of the week is: "I'm confused as to how the Fed's decrease in interest rates is affecting
bond values. It seems like Treasuries have lost value since the Fed action in early
January 2001. What can reasonably be expected for bonds the rest of 2001?"
Let's first look at what happened. On Jan. 3, the Federal
Reserve Board cut interest rates from 6.5 percent to 6.0 percent. The move took the
capital markets by surprise; in part because it didn't happen during a scheduled meeting,
which is when the Fed would usually make such cuts. It could actually be considered to
have been an emergency measure to bolster the economy. Most analysts perceive that there
will be another cut during the regularly scheduled meeting later this month.
Over the past several months, equity market analysts have
indicated growing concern about whether last year's rate increases may have slowed down
the economy more than the Fed intended. Indeed, there are concerns about whether we might
be headed for a recession. (If I seem overly critical, it's because I had a television
appearance on Jan. 3 that was drastically scaled back because of the Fed news. I hate
getting pre-empted.) The stock market responded very favorably to the news of the cut,
although it could be said that the 14 percent jump in the NASDAQ was an overreaction.
Over the past few years, Fed Chairman Alan Greenspan has
seemed to be able to wave a magic wand and set monetary policy to allow reasonable growth
with low inflation. Is his magic wand finally running out of steam? The interest rate
increases last year may have been too high and too fast. (Hey, here's a cool movie plot. A
puppeteer finds a secret passageway into the mind of a Federal Reserve Chairman, buys many
put options, and fiendishly starts wreaking havoc with the U.S. stock market.)
What About Bonds?
The reader seems confused about the effect the interest
rate cuts had on bond values. This is understandable. If the Fed ordered a decrease in
short-term interest rates, it seems logical that this would cause longer-term rates to
drop as well, which in turn would cause bond values to rise (remember, there is an inverse
relationship between market interest rates and bond values).
However, a cut in short-term rates could lead to inflation
over the long term, which would cause bond values to fall. Still, in my opinion, this is
not the reason why bond prices fell after the Fed cuts either.
Usually the bond market is impacted by either expectations
of future inflation or other national or international monetary factors. However, lately
the market has been driven by basic demand. The demand for one security compared to the
demand for another is something that impacts all prices in the market. Many investors who
didn't want to invest in the stock market in the second half of last year put their money
in bonds instead. That is why the bond market did very well during 2000. When the Fed cut
rates, however, many investors wanted to come back into the stock market. To purchase
stocks, many of those investors sold bonds, which caused the prices to fall. So, it wasn't
the rate cut by itself that hurt bonds. The rate cut increased stock values, which for a
short time were competing with bonds for investors' attention.
The Bond Outlook
What can be expected in 2001? In my opinion, while bonds
can play an important role in a diversified portfolio, one should never invest in bonds
with the expectation of large capital gains. There are years when interest rates will
increase and cause prices to fall. And, there will be years like last year when the
reverse occurred. However, I think it would be a mistake for an investor —
particularly one with long-term goals — to invest in bonds hoping for short-term
gains. The yield on short-term bonds is currently just under 5 percent, and that would be
a reasonable expectation to have going forward. |
