The Fed's Interest Rates
The Federal Reserve's decisions on interest rates have a significant influence on financial markets and the overall economy. One key rate set by the Fed is the federal funds rate. This impacts shorter-term interest rates as well as rates on everything from Treasuries to corporate bonds.
In this article, we'll explore what exactly the federal funds rate is, how it is determined, and most importantly, how changes to it impact the prices and yields of Treasuries and other major types of bonds.
"The Fed's policies ripple through markets and ultimately impact consumers and businesses alike."
What is the Federal Funds Rate?
The federal funds rate is the interest rate banks charge each other for overnight lending. It is a key benchmark rate that influences many short-term interest rates.
- Set by Federal Open Market Committee (FOMC)
- Target range - currently between 4.50% and 4.75%
- Lowered to near zero during Great Recession, now steadily increasing
- Impacts prime rates that banks extend to customers
The Fed adjusts this rate through open market operations to either stimulate or cool down the overall economy. Lower rates make borrowing money cheaper, encouraging more lending and investment. Higher rates make borrowing more expensive, reining in overheated asset prices and inflation.
How Do Changes to the Fed Rate Impact Treasuries?
Treasuries, also known as T-Notes, are debt securities issued by the U.S. government. They come in various maturities from 1-month out to 30 years.
- Treasuries have no risk of default and are considered the closest thing to a "risk-free" investment
- Yields on Treasuries move inverse to prices based on supply and demand
- When the Fed raises rates, yields on new Treasury issues tend to rise in tandem
- Similarly, rate cuts lead to lower yields on newly issued Treasuries
For example, when the FOMC raised its benchmark rate 0.75% in June 2022, the yield on the 10-year Treasury note increased from around 2.75% to over 3%.
Shorter-term Treasuries are more directly impacted by changes to the Fed's target rate, while longer-term yields are influenced more by inflation expectations and bond market demand.
- 1-month T-Bill - most sensitive to Fed rate moves
- 10-year T-Note - reflects future rate policy and economic outlook
- 30-year T-Bond - acts more like long-term fixed rate mortgage bonds
So Fed interest rate policy has a significant influence over Treasuries across maturities. Rising rates put downward pressure on prices and cause yields on new bonds to increase in turn.
How Do Changes to the Fed Rate Impact Corporate/Municipal Bonds?
Beyond government debt, changes to the Fed's interest rate policy also impact corporate and municipal bonds:
Corporate Bonds
- Issued by companies to raise funds for business operations
- Vary from short to long-term maturities
- Credit ratings and yields differ greatly based on risk profiles
Municipal Bonds
- Issued by states, cities and counties to fund public infrastructure projects
- Tax-advantaged due to income being tax-exempt
- Typically have high credit ratings and low default risk
The prices and yields on these bonds don't necessarily move in sync with the Fed's changes. Other factors like credit risk premiums, economic growth, stock market performance and inflation have significant influence too.
However, some broad trends emerge:
- Lower-rated corporate "junk" bonds are more impacted by Fed rate moves
- Short-term corporate bonds tend to align more closely with federal funds rate
- Tax-exempt municipal bonds tend to be less sensitive overall
For example, when the Fed cuts rates, prices may rise rapidly for low-investment grade corporate bonds versus more modest impacts to municipal issues.
So the level of rate impacts varies greatly depending on the type and characteristics of the bonds in question.
Conclusion
The Federal Reserve's monetary policy decisions, especially changes to the federal funds rate, have a ripple effect across financial markets. As we explored, Treasuries and bonds ranging from short-term T-Bills to long-term corporate debt respond to the Fed's interest rate moves.
However, the degree and timing of impact differs depending on factors like:
- Maturity length (short-term vs long-term)
- Credit risk level
- Tax status
Generally, shorter-maturity government-backed securities like 1-month Treasuries align closely with federal funds rate changes. Long-dated bonds and tax-exempt municipals are less sensitive in response. Lower-grade corporates also tend to react strongly in the short-to-medium term.
"While they may not directly set or control long-term corporate, municipal or mortgage rates, the Federal Reserve's actions indirectly influence the returns and risks across all bond asset classes."
So when debating Fed policy such as rate hikes to tame inflation versus cuts to spur growth, it’s important to realize the downstream effects across debt capital markets that ultimately impact businesses and consumers too.
The interwoven nature of U.S. financial markets means Fed interest rate policy has a powerful influence over Treasuries and bonds of all types.
