The Federal Reserve implemented an aggressive interest rate policy, leading to a cumulative increase of 5.00% in the Fed funds rate from March 2022 to May 2023, aimed at controlling inflation. As we approach the end of the hiking cycle, the most recent data on inflation indicates a consistent slowdown for the past ten months. This can be attributed to the delayed impact of reducing the money supply and raising interest rates, which has started to affect various inflation indicators. In June 2022, the year-over-year inflation reached its peak at 9.1%. However, it has since declined to 4.9%, which is still significantly higher than the Federal Reserve’s target inflation rate of 2% annually. Despite this, following its latest meeting, the central bank hinted at a possible pause in rate hikes, stating that it will closely monitor incoming information and assess its implications for monetary policy.

What happens to bonds if interest rates drop?

When interest rates fall, bond prices typically rise, and there may be an opportunity to profit if an investor sells the bond before maturity. For instance, if rates drop 1%, previously issued bonds are more attractive than current ones, as debt issuers will take full advantage of the now lower rates, so investors would be willing to pay a premium — above the par value — for those bonds. If an investor sells when the bond is trading at a premium, they can profit from the capital appreciation and the income earned up to that point on the bond.

Bond’s comeback

Let’s look at the long end of the yield curve or the “TLT” (20+ Year Treasury Bond ETF); given the incredible drop over the last two years, bottoming at the -2 standard deviations line, it still looks undervalued, trading over one standard deviation, below its mean value of 126.