This week, the Federal Reserve is expected to announce whether it intends to begin raising short-term interest rates. Many investors believe that interest rates are headed higher-- if not now, then eventually. Do rising interest rates translate into future negative returns for bonds?
When a rate increase is anticipated in the financial markets, bond investors naturally worry that the value of their fixed income holdings will decline. Bond values typically move in the opposite direction from interest rates, so a rise in rates will normally correspond to an immediate drop in bond values.
The central bank only sets short-term rates. Intermediate- and long-term bond rates are established in the open market by bond market participants, which is beyond the Fed's direct control. Thus, even if one can anticipate Federal Reserve actions with precision, it's very difficult to predict how bond rates will be affected over the following year or more.
Further, it's quite possible that an increase in the Fed rate might actually reduce longer term rates. This might happen, for instance, if investors view the Fed's move as a deterrent to inflation. It can also occur when a rate increase is intended to slow an overheated economy.
Jim Parker of Dimensional Fund Advisors studied the connection between central bank actions and subsequent bond market performance. In late 2013, he sampled four rising-rate periods of the past 30 years, including the high inflationary years of the late-1970s (when rates skyrocketed 15.25%) through the early 2000s.
His findings might surprise you.