The bond market is visibly affected
by changes in short-term interest rates.
If the Fed initiates a rate increase, short-term interest rates climb. If it
initiates a rate drop, short-term rates drop. And all things being equal, longer-term
rates eventually follow that lead.
That's because changing short-term interest rates affect investors' attitudes
about long-term bonds. When short-term rates are low, investors' demand for long-term
bonds increases, which increases their price. That means lower yields for
investors. But it gives would-be borrowers the incentive to issue new bonds.
When short-term rates are high, investors' demand for long-term bonds drops,
and their price falls. That raises the yield on long-term bonds. But it also
makes borrowers reluctant to issue new bonds.
Since changing interest rates affect the value of existing bonds, they also affect
the health of financial institutions and individual investors with bonds in their
portfolios. Briefly, when rates go up, existing bonds are worth less. And when
rates go down, existing bonds are worth more.
That’s true because bonds paying less than the current interest rate are
worth less than their face value, and bonds paying more than the current rate
are worth more than their face value.
Anthony Santomero,
Federal Reserve
Bank of Philadelphia
Anthony Santomero, 
