Bond strategy in rising rate environment

Question

During a period of rising interest rates, it makes sense for investors to either swap out their longer term bonds for shorter ones, or simply invest in shorter maturity bonds in order to reduce duration, as well as reinvest in higher rates if they occur. However if investors start shifting to the shorter maturity bonds that should cause yields for shorter bonds to decrease. My question is what causes those shorter yields to actually rise, and prevent that demand from causing short term rates to stay artificially low. Is the FED stepping in at that point through FOMC to make sure that rates actually increase?

In addition, why are short term bonds more impacted by changing economic indicators/beliefs compared to longer term ones?

Answer 1

Short term bonds are closely tied to the Fed funds rate. The Fed can only control the short-end of the curve, while the long-end is tied to economic growth, inflation, term premia.

When Fed embarks on a hiking path, they are putting pressure at the front-end of the curve. It's not just the fact that they are hiking rates but expectations that they will hike causes the front-end to rise.

Answer 2

In our current environment the Fed sets a floor to the interest earned on cash. This is IOER - Interest on Excess Reserves. In general, most large lenders will not lend below that rate. Entities without access to IOER will usually access the repo market to lend their money that way . The Repo market is anchored by IOER as well as many of the participants there have IEOR rate acccess.

Answer 3

Not only in the U.S., but I'd venture to say in all developed countries, the short end of the curve is controlled not by the market, but by the central bank. Only further out, the curve is controlled by the market, with the forwards being the market's view on what the shorter-term rates will be in the future.