Bonds Have Perked Up, So Pay Attention

It finally happened - the Federal Reserve cut interest rates in September. That should have been a big day for bonds, right? (When interest rates fall, bond prices rise.)  But bond prices barely moved on the day of the cut.

Why? Because bonds had already risen in expectation of September’s interest rate cut. The Bloomberg U.S. Aggregate Bond Index, a widely used measure of the bond market, rose 5.83% in the six months leading up to the rate cut. If you’d waited until the day of the cut to move cash into bonds, you’d have missed that run-up.

Bonds price in expectations of events in advance. It’s always important to have a bond allocation in your portfolio to reap the potential benefit – including expectations of Fed rate cuts.

What’s in store?

The Fed has signaled more rate cuts may be in the offing. But we don’t know when the cuts could happen, how big and how many there may be.

Why is it so hard to predict the direction of interest rates and bond prices? 

First, the Fed steers its interest rates up or down to meet its dual mandate of keeping inflation low (around 2%) and maintaining solid employment. These goals can be in conflict with each other.

Just take 2024 as an example. While the market expected the Fed to cut rates this year, these hopes sometimes rose when the data showed inflation declining faster than expected, and these hopes fell when it looked like inflation might be stickier. As a result, the increase in bond prices was bumpy.

Second, the Fed only controls short-term interest rates. Longer-term interest rates (like 10-year Treasurys) move based on what the Fed is expected to do, but also can be influenced by the economy, inflation and geopolitics. Furthermore, there are a variety of bonds that respond differently.

What does this mean for you

Investing in bonds involves risk, just as investing in other asset classes does. If you eliminate the risk, you’ll eliminate the kind of returns we saw in the months before the Fed’s rate cut.  You should diversify your risks both within bonds - by holding a mix of bonds, such as Treasurys, corporate and mortgage bonds - and across asset classes like large-cap and international stocks.

Having a diversified portfolio can help you capture unpredictable returns across a variety of asset classes and can help manage your risk before events happen.