As an investor, it is important to understand how interest rates affect bonds. Once you understand this relationship, you can keep a keen eye on the Federal Reserve’s adjustments of interest rates to identify a buying opportunity. The Great Bond Massacre of 1994 is a great example of this investing lesson.
During the 1990s, the United States economy was expanding alongside other developed countries. As our economy continued to grow, the Federal Reserve increased the interest rates because of their inflation expectations. Inflation is the increase in prices and the fall in the purchasing value of money. When interest rates are low, it is easier for people to borrow money from banks, which they then pump back into the economy. When there is more money in the economy, prices of goods and services go up, and inflation is before us. To combat inflation, the Federal Reserve can control how much money is in the economy by adjusting the interest rate.
When the Fed’s rose the interest rates because of their inflation expectations, they created more volatility in the markets. If there is one takeaway from this event, it is that incorrect expectations can create buying opportunities. In 1994, the Federal Reserve increased the Effective Federal Funds Rate by about 2.5% after inflation slightly increased. This rate increase caused a shock to the bond market for two reasons:
The rate increase made short-term bonds unattractive to investors as they could go find another short-term bond at a higher interest rate created by the actions of the Federal Reserve.
The ongoing inflation expectations during rate increases negatively affect bonds due further into the future. Bonds with longer maturities are negatively impacted by inflation because bond investors can get a higher return on a similar bond at a later date if inflation continues.
The massacre of bond prices created a buying opportunity for investors because the markets were disconnected from reality. Inflation was starting to slow down while GDP was still growing. Longer maturity bonds began to look attractive to investment companies, so once the bonds yielded high-interest rates, they were snapped up quickly. After 1994, the reality was that inflation had dropped, the stock market rallied, and longer maturity bond prices were driven up. Expectations and reactions by the Federal Reserve were overdone, and as a result, those paying attention to the economy could have made some serious money if they invested during the bond massacre.
There is a wide array of factors that can affect the economy and at Fogel Capital Management, we are constantly monitoring this information using our databases and systems to take the right steps with your money. For over 20 years, Fogel Capital Management has managed high-quality portfolios with your risk profile and needs in mind. Call (772) 223-9686 to schedule a free portfolio consultation or to learn more about our market knowledge.