Behavioral finance is a field of study that looks at behavioral and cognitive psychology in tandem with conventional economics and finance to explain why investors do what they do – tells us investors have been known to make decisions based on faulty reasoning. In some cases, they tend to classify new information based on experience or knowledge.
For instance, people who adhere to the idea that U.K. & U.S. government bonds are low-risk investments might be inclined to take in their stride the news that geopolitical tensions pushed bond yields lower during the past two weeks. Who cares that yields are at a low for the year? Government bonds are not risky investments, right?
Not necessarily. While it’s true that U.K. & U.S. Treasury bonds are backed by the full faith and credit of the government, they are still subject to the unpredictable changes in the markets. One thing to remember is interest rates and bond prices interact like children on a seesaw. When interest rates go down, bond prices go up. When interest rates go up, bond prices go down. Bond prices generally have been going up since the early 1980s and rates are currently at very low levels. As economies recover and rates start to rise again, bond prices are likely to fall and could have a negative effect on the value of portfolios holding government bonds, particularly those with longer durations.
Bond yields have stayed low during recent years largely because of monetary policy. President of the Federal Reserve Bank of St. Louis James Bullard recently said there is a mismatch between our macroeconomic goals and the stance of monetary policy. While this mismatch is not currently causing problems for the economy, it may in the future. This week, Fed officials are expected to discuss when and how to begin lifting rates from near zero – a level they’ve been at since 2008.
Meanwhile, in the U.K., Mark Carney has sent the strongest signal yet that the Bank of England is preparing to raise interest rates. Speaking to business leaders in Glasgow, Mr Carney said the economy “is starting to head back to normal” and as it does so, “the bank rate will need to start to rise in order to achieve the inflation target”.