We've been talking a lot about rising interest rates and the damage they could have on the price of bonds. Previous blog posts, such as “A Sea Change in Fixed Income
”, and our “Fixed Income Essentials
” October 2013 newsletter alluded to the sensitivity of high duration bonds to rising interest rates. We thought it might be worth revisiting the issue since the Federal Reserve is essentially finished with the Quantitative Easing program, opening the way for potential rate increases.
Take a look at the included graph. The blue line represents Treasury Bill yields (as of last Wednesday). As a reminder, the Federal Reserve can set a floor on interest rates. Right now that floor is essentially 0%, and short term treasury bills are sitting right on that floor. In other words, the shortest duration treasury bills are yielding almost nothing. Now, imagine the treasury raised interest rates 1%. The red line represents a perfect 1% shift of treasury bill yields for all durations. For example, if a 20 year treasury bill yielded 3%, now the 20 year treasury bill yields 4%.
Here’s the trick: yield curves don’t move in perfect lock step with interest rate changes. The shape of the yield curve is determined by supply and demand. It’s true that the Fed has direct control – a “floor” that directly influences short term interest rates, but the laws of supply and demand have greater influence on bond interest rates as bond maturities increase.
We've included a purely hypothetical green line which represents a flatter yield curve than what we have today. So, if the Federal Reserve increases rates to 1%, and the long term expectations of growth and safety remain unchanged, we may end up with a flatter interest rate curve where long duration bond yields don’t move as much as short duration securities.