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attractive relative to others, the pool of money is shifted from the outof-
favor instruments to the favorable one. There are times when the
prices of real estate, stocks, or precious metals are too high to justify or
too volatile to stomach. In these cases investors siphon out their money
from these investments and pour it into bonds, most notably the safe
long bond. This is sometimes referred to as "flight to quality," where
although bonds may not provide as sexy of a return as other
investments, they have guaranteed income (interest payments) and, in
the case of the long bond, are backed by the federal government. This
demand for bonds causes their prices to move up. The reverse is also
true when investors may decide to sell their bond holdings to move to
other attractive investments. In that case bond prices drop in response
to the sell-off.
Fed Moves
The Federal Reserve has a significant impact on bond prices. That is
because the Fed is tasked with adjusting the interest rates to keep the
economy on course for moderate expansion and to head off
inflationary threats. As we discussed earlier, the Fed basically makes the
adjustments to the overnight lending (federal funds) rate. However
such changes quickly cascade to bond prices such that the yields come
in alignment with the overall interest rate picture. The Fed is under
constant scrutiny by the media and financial institutions for any hints
of possible interest rate actions. The slightest indication of possible Fed
action could send the bond prices in the anticipated direction. For
example, if it is anticipated that the Fed will raise interest rates, or if the
Fed does so unexpectedly, bond prices move lower, causing the bond
yields to move up, proportionally matching the Fed interest rate hike.
An interest rate cut by the Fed has the opposite effect, and bond prices
move higher in response. …
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