If the stock market is Paul McCartney, then the bond market is Ringo Starr. It’s traditionally seen as boring and stable, but this year, it might as well be Harry Styles selling out his 15-night residency at Madison Square Garden. Every day, headlines are filled will stories about Treasuries, interest rates, the yield curve, and a myriad of other bond related issues.
So what does it all mean? And why should you care? It all comes back to inflation. Interest rates are one of the Fed’s primary tools to bring it back under control—in August the consumer price index was 8.3% while target inflation is 2.0%. Higher interest rates make borrowing more expensive, reducing the appetite for spending and thereby curbing inflation.
While the Fed can only directly influence the Fed Funds Rate (the rate banks pay to borrow money overnight), that rate indirectly influences every other rate from Treasuries and corporate bonds to mortgages and car notes. In other words, there’s a trickle-down effect from the rate banks pay to every other rate in the market.
The most obvious example is mortgage interest rates. Through September of this year, the Fed Funds Rate has increased from 0% to 3.25%, and average mortgage rates have risen from 3.22% to 6.70%. While it may not seem like a huge difference, for a $300,000 mortgage, that creates a $635 increase in monthly payments.
But higher interest rates also affect your portfolio—both stocks and bonds. For stocks, the direct effects are twofold. First, companies must borrow at higher rates, which creates higher interest expenses and lower earnings. Second, higher interest rates lower the present value of future earnings, decreasing the value of the corporate stocks. Indirectly, lower consumer spending also lowers earnings.
For bonds, higher interest rates are good for new bond purchases, but bad for bonds already in your portfolio. For example, if you own Bond A from a company that pays 3%, but the same company later issues Bond B that pays 5%, Bond A will drop in value because it’s paying less in interest. This reality is why bond yields and bond prices move in the opposite direction, which can be counterintuitive to the casual observer.
Bonds are far from boring, and actions by the Fed and other central banks along with reactions from pension funds and major financial institutions can create tremendous volatility in both the stock and bond market—something we observed in the last week of September with the UK. Unfortunately, this volatility will likely continue as the Fed battles inflation, the war in Ukraine disrupts the European economy, and tensions between China and Taiwan create uncertainty.
However, investing is an endurance endeavor, and bad news won’t last forever. A recent poll from the American Association of Individual Investors showed that expectations that the stock market will fall over the next six months recently reached its highest level since March 2009. Interestingly, March 2009 was also the bottom after the 2008 Global Financial Crisis.
Josh Norris is an Investment Advisory Representative of LeFleur Financial. Josh can be reached at josh@LeFleurFinancial.com.
Josh Norris, CPA, CFP, CFA is the managing member of LeFleur Financial, a wealth management and tax advisory firm.