• Wealth Management

Three Ways for Investors to Make Sense of Rising Rates

At some point, much higher interest rates could be a headwind for the stock market, but I don’t think we’re there yet.

Markets have generally been a lot calmer in May compared to earlier this year. But the normally tame market for U.S. government bonds is an exception. The yield on the 10-year Treasury note, the most important benchmark for interest rates, has jumped, topping 3.1% last week for the first time since 2011.

For investors that own intermediate government bonds, those rising rates add up to paper losses since bond prices move inversely to interest rates. Rising rates can also slow the economy by making it more expensive for companies and consumers to borrow money or pay the interest on existing debt.

That’s a major reason rising rates can be a headwind for markets, which was a concern of mine earlier this year. But I’m not as concerned now about higher rates dragging down the broader market. Here are three reasons:

  • The rise in yields isn’t driven just by inflation, but also by solid economic growth. That validates my thesis that we are in the late stages of a period of economic expansion that can continue for a while longer. Indeed, recent economic data in the U.S. points to a rebound in capital spending and retail sales in the second quarter from a slower first quarter.
  • Long-term rates are rising faster than short-term rates lately. The recent steepening of the yield curve is a positive for the economic outlook. Investors worry when the yield curve inverts (or short-term rates are higher than long-term rates), which is a signal that a recession may be coming. But even when rates invert, my research shows a recession is usually at least a year off.
  • The Federal Reserve has not gotten more aggressive about raising interest rates. The Fed is likely to raise rates a few more times this year and the market has priced that in. Inflation expectations aren’t rising, which is one reason stock market volatility is more muted lately.

For these reasons, I think interest rates are not at a level to disrupt equity markets and the bull market in stocks can continue. However, I do have ongoing technical concerns about the bond market.

Foreign governments (not just China), are big holders of U.S. Treasuries and some of them are starting to sell. If this continues, Treasury supply could easily exceed demand. Also increasing supply: the U.S. government is issuing a flood of new debt to cover its expanding budget and larger deficit. Both factors could drive up Treasury yields.

I suggest investors avoid long-term bonds, despite the higher yields, and turn to short-term bonds or even money market funds for new money they want to allocate to fixed income. I believe yields of long duration bonds could move higher from here (as bond prices fall).

With rising rates, investors are getting paid more to hold long government bonds. But I still don’t think they are getting paid enough given uncertainty about the future. There may be higher yields at better prices ahead.

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