Investors hoping for a reprieve after months of short-term interest rate hikes from the Federal Reserve may have longer to wait before rates settle back down amid a rapid ascent in longer-term government bond yields.
In fact, the yield on the 10-year Treasury note has climbed an entire percentage point over the past few months and is now at a 16-year high around 4.7%, rattling equity investors and driving a retreat in benchmark stock indices.
To understand why, recall that interest rates were near zero just a few years ago. This gave consumers, businesses and investors access to cheap money, which supported lofty stock valuations, during the era of “secular stagnation”—characterized by low economic growth, low inflation and low rates—following the 2007-2008 financial crisis.
Some investors today might view the recent rise in longer-term rates as temporary and hope for a quick return to that era. While we do see the U.S. economy possibly slowing and interest rates declining over the next nine to 12 months, there are mounting risks that rates could instead stay elevated alongside robust growth and persistent inflationary pressures.
We see two key factors that could keep rates higher in the near term:
- A resilient economy and a tight labor market mean inflation remains a threat. Even with all the interest rate hikes over the past 18 months, households and businesses have been spending money and keeping the economy more robust than previously expected. The labor market also remains tight and capital spending has been consistent. These factors suggest inflation is still a threat, and the Fed will have to crush consumption or the labor market—or both—to bring inflation back to target, which translates to a floor under rates for a while.
- The U.S. government has issued a surge of debt that could see fewer buyers. For instance, the traditional banking system is funding itself through reserves rather than Treasuries, and foreign buyers may be pulling away as well, with Japanese investors constrained by yen weakness, and China continuing to reduce its share of U.S. bond purchases since 2018. Political wrangling in Washington doesn’t help investor confidence in the Treasuries market, either. With deficit sustainability remaining an issue, the price of money likely stays elevated.
So how high could rates go? We believe longer-term government bond yields are likely to normalize somewhere between 4.5% and 5.5%. Our logic is that the post-COVID U.S. economy looks more like the post-World War II period than the era of secular stagnation, with growth and inflation around 2.5% to 3% driving investors to demand rates in this higher range.
How to Invest
All this considered, our investment approach remains cautious and defensive. We continue to emphasize rebalancing portfolios toward intermediate duration in fixed income, where strong value and historically high levels of yield may be found.
In equities, investors face a “Faustian” bargain: Lower interest rates tend to support higher valuations, but the only way for the Fed to lower rates may be to weaken economic growth and the job market—not a good thing for corporate earnings. With U.S. stock indices likely to trade in a fairly static range for the next few quarters, investors should consider neutralizing extreme sector and factor over-weights in their portfolio and balancing equity exposure between offense and defense, with a focus on quality.
This article is based on Lisa Shalett’s Global Investment Committee Weekly report from October 9, 2023, “The Bear Steepening.” Ask your Morgan Stanley Financial Advisor for a copy. Listen to the audiocast based on this report.