The Facts

The 10-year US Treasury bond bottomed in July of 2016.  Since then, the interest rate on the 10-year has more than doubled from 1.39% to 2.9%.  At the same time, the Federal Reserve Bank has lifted short term rates from .50% to 1.75%.  On March 21st, the new Fed Chairman, Jerome Powell, said he expects to make two more short term rate hikes this year and likely three next year, based on anticipated economic growth and continued low unemployment. 

Rising Rates 

The Bad

•      If rates go up, it makes borrowing money more expensive.  Higher interest rates on a car loan or mortgage will increase your monthly payment amount.  This effect can cause housing prices to go down due to affordability issues. 

•      Older bonds purchased at lower interest rates will go down in price.  Why would you buy a bond with a 1.4% interest rate at the same price as one that pays you 2.9%?

•      The Good

•      The current rate offered on your money market fund, a newly purchased CD, and bonds will be higher. But it’s only good if rates stop increasing. 

What causes rising interest rates?

•      Market data can cause interest rates to rise.  In February 2018, a government report showed a jump in wage growth which strongly increased concerns about inflation.  Subsequently, bond yields increased. 

•      Larger borrowing needs by the U.S. government and corporations puts pressure on rates.  If there isn’t a lot of demand for new issue bonds, the interest rate needs to increase to attract buyers.  

·       The recently passed tax bill increases the US budget deficit, so the U.S. Treasury has to issue additional bonds to finance it.

·       Adding fuel to the Treasury’s fire is a trillion dollars of corporate debt that needs to be refinanced in the next three years.

What causes Inflation?

•      Low unemployment rates due to a growing economyoften causes inflation. This can be exacerbated by demographic changes and a lack of immigrant workers.  Businesses must pay more to attract workers, and these higher wages are passed on in higher costs of goods and services. 

•      A weaker dollar versus other currencies may cause inflation because we must pay more to buy imported goods.  When imported goods prices go up, domestic prices on competing goods can be raised as well. 

•      Rising commodity prices (oil, copper, lumber to name a few) can cause inflation.  As world economies grow, and businesses use more energy and materials, demand for those commodities increases.  Commodity price increases are then passed on in the cost of goods and services that people buy.  

•      International tariffs, like a lower dollar cause the cost of imported goods to increase, allowing U.S. companies to raise their prices.

How do rising rates and inflation affect your portfolio?

Bonds

•      Older bonds purchased at lower interest rates will go down in price.  

•      Your existing bond portfolio at a fixed interest rate will have difficulty keeping up with inflation, resulting in diminished purchasing power.

•      The combination of low yields and falling bond prices means that bonds are not currently providing as good a hedge against falling stock prices. This is contrary to the typical relationship between stocks and bonds.    

•      Stocks 

•      The price of a company’s stock depends on how much someone is willing to pay for a company’s future earnings.  When rates go up, investors use a higher discount rate for those earnings, making the stock price go down.

•      If rates rise significantly, higher priced newly issued bonds become competition for stocks.

So, what's a prudent investor to do?  

These are challenging times with implied lower rates of return.  We would suggest looking at alternative asset allocations to longer dated bonds.  It's an excellent time to re-evaluate your portfolio and make sure your portfolio asset allocation is right for these markets.  Advisors who provide tactical asset allocation will provide this service.