• Wealth Management

Get Ready for Rising Rates

Some market experts think interest rates will stay low next year. But there are at least four reasons they are likely to rise.

Predicting a rise in U.S. interest rates next year seems like a pretty easy call. The benchmark 10-year Treasury yield tends to correlate with rising inflation expectations. The economy is growing nicely and unemployment is falling, factors that typically lead to higher inflation—even before Congress cuts taxes, as it seems set to do. Assuming lower taxes are implemented, that would stimulate the economy and inflation could rise even faster. 

Plus, the Federal Reserve has raised short term rates three times this year and indicated recently it would hike three more times next year. 

Nonetheless, forecasting a significant rise in long-term interest rates has become a controversial call—mainly because it hasn’t happened, despite years of economic recovery. Most of this year, the 10-year yield has stayed in a remarkably narrow range between 2.25% and 2.50%. 

Another reason rates have stayed low is strong demand for Treasurys in the U.S. and globally. That’s kept prices high and yields low (bond yields move inversely to prices). While Treasury yields may seem unappetizing to U.S. investors, they are much higher than in some other developed markets—like Germany. Plus, global central banks have bond-buying programs in place, stimulating demand. Another reason rates have stayed low is a cautious Fed that was reluctant to hike rates too fast when inflation remained low.

The reason I have a different outlook for the future direction of rates is that some of those trends seem poised to reverse. Consider these four scenarios:

  • Inflation is likely to rise, boosted by tax cuts which seem about to pass. 
  • Lower taxes would likely lead to larger deficits, which could require the Treasury to issue more debt, increasing the supply of government bonds on the market.
  • Some global central banks are expected to scale back on their bond buying programs next year as their economies improve. That means more supply, less demand for Treasurys.
  • There is a changing of the guard at the Fed, which is likely to lean more hawkish in the future. That could spark volatility in bond markets.

Bottom Line: While I can see rates falling later in the year, it would likely be preceded by a spike in volatility and higher interest rates. My advice for investors now is to adjust their bond portfolios so that more of their investments are in short-term bonds. Later in 2018, if financial conditions worsen and the 10-year Treasury rises as I expect, that could be a good time to add more long-term bonds.

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MORGAN STANLEY ACCESS INVESTING