When the Federal Reserve (Fed) cuts interest rates, the price of bonds generally tends to rise. This relationship is a fundamental concept in bond market dynamics and is known as the inverse relationship between interest rates and bond prices.
Here's why this happens:
Inverse Relationship: Bond prices and interest rates have an inverse relationship. When interest rates fall, the prices of existing bonds with higher yields become more attractive to investors.
Yield and Price Movement: The yield on a bond is essentially the return an investor earns from holding the bond. When interest rates decrease, newly issued bonds offer lower yields. Existing bonds with higher fixed interest rates are more appealing because they provide a relatively higher yield compared to new bonds.
Price Adjustment: To make existing bonds with higher coupon rates competitive in the new, lower interest rate environment, their prices must rise. This price increase is necessary to bring the effective yield of these existing bonds in line with the lower prevailing interest rates.
Duration Risk: It's important to note that the degree of price movement depends on the bond's duration. Bonds with longer durations are generally more sensitive to interest rate changes. Duration is a measure of a bond's sensitivity to interest rate movements; the higher the duration, the more the bond's price will change in response to interest rate changes.
Investors need to be aware that while bond prices may rise in response to interest rate cuts, other factors such as economic conditions, inflation expectations, and overall market sentiment also play a role in determining bond prices. Additionally, the specific type of bonds in the market (e.g., government bonds, corporate bonds) can influence how they respond to changes in interest rates.