Interest Rate Timing

January 08, 2024

The Federal Reserve decided in December to keep the Federal Funds Rate at the current level between 5.25% and 5.5%. The Fed has kept the rate there since July 2023. While keeping the rate constant would seem to be a non-issue, the market took it very differently. The bond market reacted to this news and has decided that interest rates will not be raised any more. Bonds rallied and some made double-digit returns since the news just a few weeks ago.

In addition to the Fed holding rates steady, they alluded to the possibility of lowering rates. This is most likely what excited the bond market. The Fed is typically expected to lower rates in response to a slow or weakening economy (recession). There have been other situations where the Fed has lowered rates without a recession. If the Fed believes inflation is under control and trending toward the target of 2% inflation, then the Fed may decide that 5.25% - 5.5% interest rates are too high and unjustified. I think they also would prefer not to be blamed if there is a recession. This would motivate the Fed to keep rates high only if they can point to high inflation. Once that is perceived as gone, the Fed would start being the bad guy and not the savior; they would prefer to be seen as the savior.

The other motivation the Fed has to lower interest rates is the inverted yield curve, where short-term interest rates are higher than long-term interest rates. This is not normal and highlights that the Fed has elevated interest rates above the natural rate that the market has set for longer-term rates. This is another reason the Fed would be blamed if a recession occurs in 2024, and the Fed would be quick to drop rates IF inflation is acceptably low.

How can we time the potential interest rate shifts to make money? Since the perception is that the Fed is now done raising interest rates, those who were ahead of this timing made a very good return over the past month buying long-term bonds. If the Fed lowers interest rates from the current level, then investors will earn even more if they are invested in long-term bonds when the Fed changes their policy.

The risk is being wrong. What if inflation spikes up? Could the Fed raise rates again? Yes, this is a real risk; if inflation does spike or even rise slightly, long-term bonds could lose big simply because there is a chance the Fed may raise rates to fight inflation. This is a gamble most people are not interested in taking. Since the majority of bond investors are looking for safer, more stable returns, the bond market is unlikely to see much speculation and timing from everyday investors.

The best time to buy long-term bonds (now or at any point) is when you are happy with the long-term interest rate and you plan to hold the bond until it matures years in the future.