Most investors care about future interest rates, but none more than bondholders. If you are considering a bond or bond fund investment, you must ask yourself whether you think treasury yield and interest rates will rise in the future. If the answer is yes, you probably want to avoid long-term maturity bonds or at least shorten the average duration of your bond holdings , or plan to weather the ensuing price decline by holding your bonds and collecting the par value when they mature. In the United States, the Treasury yield curve or term structure is the first mover of all domestic interest rates and an influential factor in setting global rates.
Interest rates on all other domestic bond categories rise and fall with Treasuries , which are the debt securities issued by the U. To attract investors, any bond or debt security that contains greater risk than that of a similar Treasury bond must offer a higher yield.
Below is a graph of the actual Treasury yield curve as of January 21, It is considered normal in shape because it slopes upward with a concave slope, as the borrowing period, or bond maturity, extends into the future:.
Consider three elements of this curve. First, it shows nominal interest rates. Inflation will erode the value of future coupon dollars and principal repayments ; the real interest rate is the return after deducting inflation. The curve, therefore, combines anticipated inflation and real interest rates.
Second, the Federal Reserve directly manipulates only the short-term interest rate at the very start of the curve. The Fed has three policy tools, but its biggest hammer is the federal funds rate , which is only a one-day, overnight rate.
Sophisticated institutional buyers have their yield requirements, which, along with their appetite for government bonds , determine how they bid. Because these buyers have informed opinions on inflation and interest rates, many consider the yield curve to be a crystal ball that already offers the best available prediction of future interest rates.
If you believe that, you also assume that only unanticipated events for example, an unanticipated increase in inflation will shift the yield curve up or down. Technically, the Treasury yield curve can change in various ways: It can move up or down a parallel shift , become flatter or steeper a shift in slope , or become more or less humped in the middle a change in curvature.
The following chart compares the year Treasury note yield red line to the two-year Treasury note yield purple line from to The spread between the two rates, the year minus the two-year, blue line is a simple measure of steepness:. We can make two observations here. Therefore, parallel shifts are common. Second, although long rates directionally follow short rates, they tend to lag in magnitude. More specifically, when short rates rise, the spread between year and two-year yields tends to narrow curve of the spread flattens and when short rates fall, the spread widens curve becomes steeper.
In particular, the increase in rates from to was accompanied by a flattening and inversion of the curve negative spread ; the drop in rates from to created a steeper curve in the spread, and; the marked drop in rates from to the end of produced an equally steep curve by historical standards. So what moves the yield curve up or down? Well, let's admit we can't do justice to the complex dynamics of capital flows that interact to produce market interest rates. But we can keep in mind that the Treasury yield curve reflects the cost of U.
Monetary Policy If the Fed wants to increase the fed funds rate, it supplies more short-term securities in open market operations. The increase in the supply of short-term securities restricts the money in circulation since borrowers give money to the Fed.
In turn, this decrease in the money supply increases the short-term interest rate because there is less money in circulation credit available for borrowers. By increasing the supply of short-term securities, the Fed is yanking up the very left end of the curve, and the nearby short-term yields will snap quickly in lockstep.
Can we predict future short-term rates? Well, the expectations theory says that long-term rates embed a prediction of future short-term rates. But if we consider the actual yield curves observed in the markets over time, unfortunately, the pure form of this theory has not performed well: Interest rates often remain flat during a normal upward-sloping yield curve.
Probably the best explanation for this is that, because a longer bond requires you to endure greater interest-rate uncertainty, there is extra yield contained in the two-year bond. If we look at the yield curve from this point of view, the two-year yield contains two elements: a prediction of the future short-term rate plus extra yield i. So we could say that, while a steeply sloping yield curve portends an increase in the short-term rate, a gently upward-sloping curve, on the other hand, portends no change in the short-term rate—the upward slope is due only to the extra yield awarded for the uncertainty associated with longer- term bonds.
Because Fed-watching is a professional sport, it is not enough to wait for an actual change in the fed funds rate, as only surprises count. It is important for you, as a bond investor, to try to stay one step ahead of the rate, anticipating rather than observing its changes.
Stripping out food, trade and energy prices, the index increased 0. On a year-over-year basis, core producer prices increased 6. Last month's consumer price index, which is more closely monitored by investors as a more direct measure of inflation, will be released at a.
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