The Pros and Cons of Rising Interest Rates, And Our Take on What May Come Next
Laurence Hale, AAMS®, CRPS®
Principal/Managing Partner, Investment Advisor & Chief Investment Officer
This year interest rates have risen to levels that haven’t been seen in more than 15 years. The 10-year Treasury yield has jumped to almost 4.9%, up from under 1.0% in 2020. The ripple effect from this large move has sent interest rates higher on all types of fixed-income products.
Banks, which paid very low interest on certificates of deposit (CDs) for many years, are now offering consumers interest rates north of 5%. Some new car buyers are paying 7.7% on a 48-month loan and home buyers are paying 8.3% on 30-year mortgages! Higher interest rates are good news for savers and bad news for borrowers. (All rates current as of November 1, 2023.)
The interest rate environment is one of many factors that WHZ evaluates when creating our all-weather, balanced, and diversified portfolios. Back in April, our expectation that interest rates would rise led us to eliminate REIT exposure for our clients and replace it with funds that invest in small- and mid-cap stocks. Doing so further diversified the portfolio.
There’s a risk that today’s higher interest rates will slow consumer spending and negatively impact overall economic growth in the coming quarters. If that occurs, it’s possible that bond prices will stop falling or even rise. So, now we are watching for opportunities to add to our portfolio’s bond exposure, particularly in the investment-grade corporate and mortgage-backed bond markets.
Given how important interest rates are to stock and bond performance, let’s explore some of the factors that have driven their direction in recent years.
BLAME THE PANDEMIC.
Today’s high interest rates have their roots in the Covid pandemic. The Federal Reserve cut interest rates to almost 0% in 2020 and the US government provided massive funding to individuals and businesses to boost economic growth. All that funding did its job. After declining briefly due to the pandemic-induced shutdown, US economy bounced back and started to grow a bit too fast.
Consumers trapped at home during the pandemic made many online purchases. Excess demand and supply chain problems caused an uptick in inflation. (Remember hunting for toilet paper?!) The price of eggs jumped and cars sold for more than their sticker price. When the pandemic ended, consumers couldn’t wait to reunite with friends and family. They packed into restaurants and planned vacations. Airline ticket prices and hotel room rates soared.
The Consumer Price Index (CPI)—which measures the increase or decrease in consumer prices—rose to a peak of 9.1% in June 2022. Bond investors demanded higher interest rates to offset the declining value of future payments in an inflationary environment.
THE FEDERAL RESERVE RESPONDS.
One of the Federal Reserve’s main jobs is to keep inflation in check, so it responded to rising prices by increasing the federal funds rate—the interest rate used determine what banks charge each other to borrow money overnight. It raised the fed Funds rate from almost 0% in 2020 to 5.3% today.
The Fed’s efforts have borne fruit. Inflation as measured by the CPI fell to 3.7% in August. The Fed’s goal is to keep inflation close to 2%, so investors are hopeful that the Federal Reserve may only raise interest rates one or two more times.
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FEDERAL DEFICITS IMPACT RATES, TOO.
If inflation has started to fall, why haven’t interest rates declined as well? Because interest rates are also affected by supply and demand. In this case supply is the amount of Treasury debt the US government sells to fund its operations and demand comes from investors.
The US government has been spending far more than it generates in revenue. The resulting deficit hit $1.7 trillion for the fiscal year ending September 30. That’s almost twice 2019’s deficit. The government raises money to cover its funding shortfall by selling Treasury bills and bonds. Year after year of deficit spending has resulted in $30.9 trillion of US debt outstanding as of September 2022, which is up by about a third over the past decade, according to inflation-adjusted US Treasury data. Now that’s a lot of supply.
From 2020 through mid-2022, the Federal Reserve was a large buyer of US Treasurys and mortgage-backed securities, as part of its Quantitative Easing program used to boost the economy during the pandemic. But now the Federal Reserve is trying to slow economic growth and it has stopped buying Treasuries (Quantitative Tightening). In reaction to more supply and less demand, interest rates have risen to attract new investors.
THE ECONOMIC IMPACT.
It takes a while for the effects of higher interest rates to trickle throughout the economy. We’ve highlighted four ways the economy could respond: It could continue to grow, it could muddle through, it could dip into a mild recession, or it could fall into a deep recession. We believe it’s most likely that the US economy will either muddle through and grow slowly or fall into a mild recession.
We’ll be keeping an eye on interest rates for our clients, and updating them (and perhaps their portfolios) if our opinion changes. Our Plan Well, Invest Well, Live Well™ strategic process may be built on a long-term approach, but maintaining that strategy in the midst of constantly changing markets requires a constant eye to economic forces and sometimes short-term adjustments along the way.
It’s a lot to manage. If you’d like help, get in touch with us at Weiss, Hale & Zahansky Strategic Financial Advisors. You can schedule a complimentary consultation on our website or simply call us at (860) 928-2341.
Authored by Principal/Managing Partner Laurence Hale AAMS, CRPS®. Securities and advisory services offered through Commonwealth Financial Network®, Member FINRA/SIPC, a Registered Investment Adviser. These materials are general in nature and do not address your specific situation. For your specific investment needs, please discuss your individual circumstances with your representative. Weiss, Hale & Zahansky Strategic Wealth Advisors does not provide tax or legal advice, and nothing in the accompanying pages should be construed as specific tax or legal advice. 697 Pomfret Street, Pomfret Center, CT 06259 and 392-A Merrow Road, Tolland, CT 06084. 860-928-2341. www.whzwealth.com.
- https://www.ft.com/content/637eb94f-b7a9-409d-8230-8b3ff512e5b0
- https://fred.stlouisfed.org/series/BAMLC0A0CMEY
- https://www.wsj.com/market-data/bonds
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