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The Federal Reserve is in the Driver’s Seat

Data as of June 6, 2021

The Federal Reserve’s job is to control the economy and not necessarily to control interest rates, except for the overnight lending rate to banks, the shortest of all interest rates.

When you hear about the Fed’s Open Market Committee Meeting coming up on a particular Wednesday, the outcome of that meeting is based on the economy and whether they need to take any further actions, or reduced actions, to control inflation and decide on whether to allow it to creep into the economy or not. Aside from the buyback programs like quantitative easing, they do it by raising or lowering the overnight lending rate.

At the end of that meeting, the Fed can’t say, “Our target for the 30-year U.S. Treasury Bond is 2.25%.” They cannot control that; it is market driven. They cannot control the 10-year, or the 7-5-3-2-year, any of the benchmark U.S. Treasury notes or bonds.

The Fed Sets the Pace

The Fed sets the pace for other maturities and Treasury bonds too. For instance, in today’s market, we have T-bills that yield nothing. Literally, that’s a minus right now. If you go all the way out to a 1-year T-bill, it is only .04 basis points. So, when it starts to climb we have a naturally ascending yield curve. Essentially, you go from nothing on a T-bill, to a 2.2+% on a 30-year bond. You can plot a curve in your mind, which is a natural ascending yield curve and a bi-product of the Fed’s actions.

The Federal Reserve would begin to believe that hyperinflation is on the horizon, because the economy is blasting off, so they want to control that. They will “put their foot on the gas” and start to raise rates. If that T-bill goes from .25 basis points, or a half of a percent or 1%, 2%, and so on, they’re raising it to try to get ahead of inflation. And those are periods where we see, like a few years ago; the yield curve flattens and can even become inverted with higher yields on the short end.

As an investor, the old saying is: “You can’t fight the Fed,” but you can move with the Fed. If you see the curve flattening, and an inversion with short-term yields being higher, you just buy and take advantage of that by selling one part of the curve and buying another part of the curve.

On August 5, 2020, the 10-year Treasury was 50 basis points (0.5%). And then it almost hit 180 -190 from August 5 to March 2021. Currently, it’s come back down a bit. The scare is out of the market and it was at 1.53%. However, along the way, if you owned 10-year maturities, you saw the value of the maturities that you bought at a .50 basis decline, because as yields rise, prices fall. That’s when you ask yourself: “Should I even own Treasuries?” The answer is probably: “No, you shouldn’t.”

What Investors Should Be Thinking and Doing

U.S. Government Treasuries are arguably the safest and most secure investment in the world. If you buy a 10-year note, you’re going to get 1.53%. If interest rates move up to 2%, you are going to be down in value, but that is not why you buy them. You buy them for the interest rate and the yield.

Everything in the United States is priced off of that Treasury yield. For instance, if you have a BBB-rated corporate bond, it is probably paying you something like .80 basis points more than a Treasury. Now, if you owned an A-rated corporate bond, sector depending, it is likely paying you .65 or .70 basis more than Treasuries. An AA-rated corporate bond is paying .50 basis more than Treasuries. But, the key here is: “more than.”

If you buy a taxable Municipal bond at that yield over Treasuries, for example, like we did at Hefren-Tillotson when we bought over half a million in short and A+ rated 10-year Treasuries, we got more than .60 basis – more yield than if I bought a Treasury bond. And municipal bonds are considered to be the second safest bond investment in the U.S.

Of course, you must always be careful with what you buy because nothing is completely safe. But if you can get one-half of one percent more than what a Treasury is paying for the second safest bond in the U.S., and if you need taxable bonds, that’s probably what you should be buying. Of course, you invest according to overall long-term strategy.

Think About Income and Preservation of Capital

The truth is more people buy bonds for preservation of capital than for income. When that is the case for you, Treasuries are your market. Taxable Munis are your market. Very high rated industrial corporate bonds are your market. Tax-Exempt Muni Bonds are for those in high tax brackets. You can get 1.53%, the same as a Treasury bond, on a very high quality tax-free municipal bond; and the tax-free equivalent yield (1.53 divided by .60) of 2.55.

People ask: “When is the best time to invest?” When you have the money!  Then, you have to take a hard look at the yield curve and what can change that curve down the road. That’s when we invest accordingly. But the BEST time to invest in the bond market is during times of trouble, like March and April of 2020, when the pandemic was real and it hit hard.

We got very concerned very quickly about how this would affect hospital bonds, university and transportation bonds, and ports around the coast because the flow of goods would be affected. Would defaults and bankruptcies occur in those sectors – like an analyst “predicted” on 60 Minutes several years ago? It put a scare into investors and destroyed the market for about three months. Fear is a powerful tool. THAT was the best time to invest.

Then and now, bond prices plummeted. However, whether 2009-2010 or now, NONE of those times ever produced massive defaults, thankfully. When people panic and sell, THAT’s also the best time to invest.

DISCLAIMER: Past performance does not predict future results. This report is based on data obtained from sources we believe to be reliable. Hefren-Tillotson does not, nor any other party, guarantee the accuracy or completeness of this report or make any warranties regarding results obtained from its usage. All opinions and estimates included in this report constitute the firms judgment as of the date of this report and are subject to change without notice. This report is for informational purposes only and is not intended as an offer or solicitation to buy or sell the securities herein mentioned.

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