Robert A. Di Ieso, Jr.
By Sarah Max
August 17, 2015

Q: Could you please explain how Fed interest rate policy influences bond prices and returns? — Dave

A: Interest rates that are set by the Federal Reserve don’t directly impact the prices and returns of the bonds that you own directly or through funds.

That’s because the Fed only sets rates on overnight loans that Federal Reserve member banks receive from the Fed itself or from one another, says Jay Sommariva, vice president and senior fixed income portfolio manager at Fort Pitt Capital Group in Pittsburgh, Penn.

As for the longer-term debt that you own in your portfolio, the state of the economy — or rather, the market’s perception of the economy — is what will ultimately determine their yields and conversely their prices. (Bond yields and prices move in the opposite direction.)

So why then are investors so fixated on the Fed’s every move?

By reducing or raising short-term rates, the Fed incrementally cuts or boosts the cost of capital to lending institutions. And that in turn can either nudge the economy toward faster growth by promoting lending or tap the breaks on economic activity if things are heating up.

In December 2008, for example, the Fed lowered its target for the so-called Federal Funds rate to near zero as one effort to stem a full-blown recession.

Now that the economy has turned a corner, investors expect that the Fed will raise its overnight target as early as next month, albeit ever so slightly.

Exactly how the market will initially react is anyone’s guess.

On the one hand, most investors have already factored such an increase into their models. Then again, “the Fed hasn’t raised rates in over eight years,” says Sommariva. “When they finally do, it could be an event.”

To be sure, just as important as what the Fed does is what the Fed says. Case in point: The “Taper Tantrum” of 2013.

When the Fed indicated that its stimulative campaign would soon be coming to an end, it wreaked temporary havoc on the bond market. Once the dust settled, prices recovered and bond yields fell again.

Bottom line: A Fed increase could translate to higher short-term interest rates — and that means a potential decline in prices. Longer-term rates, however, tend to hinge on what investors think about inflation and the economy, as well as what else is happening in the world. Sommariva adds that short-term rates could rise even as longer-term rates come down.

Then again, considering that the yield on 10-year Treasuries has, for the most part, been in steady decline for the last three decades, yields don’t have much room to fall.

At some point they will head higher, and when that happens prices could decline.

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