Intermediate Bondage

Intermediate Bondage
Here at Financology we often talk about short and long term bonds, and explicitly track and forecast them in Synthetic Systems.  Medium term bonds are usually just not that interesting.  But they have become so of late, in the sense of that old Chinese curse, “May you live in interesting times.”

By the standards of this asset class, it’s been blood in the streets.  The usually staid Vanguard Intermediate Treasury fund, which covers the Treasury market from 3-10 years maturity, has collapsed by nearly 2 1/2% in barely three weeks.  More broadly, Treasuries from 1-10 years have been hard hit, as the Federal Reserve has at long last begun to sit up and take notice of the highest official inflation readings in forty years.

Why?  The shortest term bonds just don’t move much when interest rates do, as a matter of arithmetic.  Furthermore, the very shortest term rates themselves haven’t moved much.  But the markets are rapidly baking them in.  Whatever short term rates are three to six months from now is part of the yield of any bond that matures in three to six months or more.  So higher short term interest rates in the near future are not merely hypothetical, they’re already in the yield curve from there on out.  Right now.

Long term rates, on the other hand, embed not only short term rates in the near future, but also short term rates in the medium term and on out to the long term.  No one knows what short term rates will be ten or twenty years from now, but their effect dilutes the effect of the near term.  So long term rates pretty much go their own way independent of near term expectations for short term rates.  In fact they may even move in opposition to short rates if the markets perceive that rising rate policy will quell inflation, thereby decreasing real losses on long term cash flows.  As it turns out, long rates have been rising too, but by their standards longer term bonds haven’t incurred the degree of losses medium term bonds have … yet.

Follow the Curve
The fact that the yield curve has already built in everything knowable about short term rates makes so much of the ink spilt in the financial media about what the Fed will do irrelevant to investors.  Talking heads may lead you to think whether the Fed will hike three times or four times this year is important, but are wasting your time.  The world’s smartest market has already worked out its expectations with far greater precision than +/-25%.  Just go to https://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yield.  The incremental increase in rates between each maturity level reflects these expectations for short rates from 1-2 months, 2-3 months, 3-6 months, etc.  

This of course is not to say that those implied forecasts will turn out be exactly correct.  But they are updated in real time.  By the time you’ve read some pundit’s Fed forecast, it’s already stale and will have been obsoleted in the yield curve.  More to the point, whatever effect Fed policy has on your investments works through the Treasury market.  In other words, what the Treasury market thinks about Fed policy is what affects your investments, not the policy itself.  

So do yourself a favor.  If following Fed policy entertains you, by all means follow it.  If you have something to say about it, say it.  As for its effect on your investments … forget about it … just follow the curve.

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