The Fed Cut Interest Rates; What Does This Mean for the Bond Market?

The Fed Cut Interest Rates; What Does This Mean for the Bond Market?

Reading time: 6 minutes

With the US Federal Reserve (Fed) reducing its benchmark lending rate by 50 basis points (bps) in September and Fed Chair Jerome Powell signalling further policy easing, this profoundly affects the bond market as well as other asset classes. For this article, the focus will be largely on government bonds.

Bonds Defined

At its simplest, a bond is an IOU, a loan for a specified amount (the principal) made by a lender (investor) to a borrower (the issuer) in return for regular cash flow payments determined by an interest rate (or ‘coupon rate’ which is fixed when the bond is issued and does not change during the lifetime of the bond). The bond's duration is determined by its ‘term to maturity’, and during the bond's lifespan, the issuer ‘promises’ to pay a specified interest rate (usually twice per year) and must repay the principal at maturity.

The bond market is one of the largest capital markets in the world. Governments issue bonds to help support purposes such as spending, funding developments, and financing debt. Corporations generally issue bonds to raise money to cover debt obligations, fund growth as well as mergers and acquisitions.  

Bond prices rise (fall), and yields simultaneously fall (rise); this is called ‘interest rate risk’. This inverse relationship between bond and yield exists due to the former’s fixed interest rate and its price fluctuating based on supply and demand in the secondary market. Therefore, changes (or expectations of shifts) in the central bank’s overnight rate influence the price of bonds. Another driving factor in the bond market is ‘maturity risk premium’, the compensation for holding longer-dated bonds over short-term bonds. Bond maturities in US government bonds (US Treasuries) range from short-term T-Bills (generally 4 weeks to 1 year in duration) to Treasury Notes (2-10 years) and Treasury Bonds (10-30 years). Typically, long-term bonds command a higher rate of return than shorter-dated bonds to compensate investors for the risk of lending money for a longer period, increasing the possibility of default. This is evident in a yield curve chart. 

Below is an example of the yield curve for US Treasuries (government bonds), from 1-month to 30-year duration. These types of bonds are considered one of the safest investments as they’re backed by the US government and are often used as the risk-free rate in many risk-adjusted formulas, such as the Sharpe ratio. Longer-dated bond yields tend to reflect the longer-term expectations of inflation and growth in the US economy, while short-term bonds are more responsive to the outlook for the Federal funds rate.

Fed Cut Rates – What Happened to Bonds?

The Fed’s long-awaited interest rate cut in September – its first rate cut in 4 years – and further rate reductions eyed have notably influenced the bond market. US Treasury yields – from short-term 2-year to 10-year notes – have fallen to reflect bond buying and investors’ expectations of additional rate cuts, which, consequently, saw demand for the US dollar soften. The yield on the benchmark 10-year note topped north of 5.00% in October 2023 and, despite a temporary run higher from 3.79% to 4.74% in early 2024, has been gradually stepping lower since. 

What does this mean for investors? Some may seek a move from cash (short-term bonds) into longer-term bonds to capture the expected price rise due to lower yields in the future. As many will know, the Fed is attempting to navigate a soft landing – lowering inflation without driving the economy into recession – and appears to be on course. Annual inflation is just north of the Fed’s 2% inflation target, the jobs market is cooling but not excessively weak (the unemployment rate is 4.2%), and economic growth is running at an annualised pace of 3%. However, the Fed is not out of the woods yet and remains cautious. 

According to September’s forecasts, the Fed is projecting another 50bps of cuts until the year's end; however, futures traders are pricing in (forecasting) that the Fed may cut rates by another 75bps. This means the Fed may swing for another 50bp cut at November’s meeting and another 25bps in December.

FAQs:

1. What are bonds?

Bonds are IOUs between a lender (typically an investor) and a borrower (the bond issuer). Corporations and governments are the largest issuers of bonds. 

2. What does a rising (falling) yield indicate?

Rising government yields reflect lower demand for bonds and indicate that investors are shifting to higher-risk alternatives, such as stocks and corporate bonds. Falling yields, on the other hand, indicate the opposite: demand for safe-haven government bonds. 

3. How do bonds react to a rate cut?

In terms of government bonds, you will often see demand for bonds in case of a rate cut or expected rate adjustment. You will also likely see investors alternate from cash to longer-duration bonds. The opposite tends to be true for a rate hike.

4. Can I use bond yields to help forecast rate adjustments?

Yes. government bonds are often used to assess investor sentiment. Imagine a scenario where an investor expects the Fed to begin reducing its overnight rate. The yield on government bonds, therefore, will also be reduced. As a result, given the possibility of a lower return on the bonds, investors will attempt to lock in the current yield by buying bonds, which in turn sends yields lower.