After hitting a record low of 0.52% last summer, the 10-year U.S. Treasury rate has risen quickly, almost tripling to 1.55% (as of March 9). This sharp rise in interest rates has hurt bond performance (because bond prices move inversely to interest rates), causing some investors to wonder what is driving rates higher.
Before exploring the reason rates have increased, it’s important to distinguish between short-term rates, which the Federal Reserve controls, and longer-term rates, which are influenced by market participants. On the short end, rates have not risen because the Fed has kept its policy rate between 0.00% and 0.25% and communicated that it doesn’t plan on raising rates for a few years. Longer-term rates, on the other hand, have shot higher as the economy begins to heal and investors look ahead to potentially higher growth and inflation as the economy reopens and additional stimulus is distributed.
To the extent that higher rates are driven by faster economic growth and higher corporate profits, higher interest rates don’t pose much risk to the stock market. However, based on breakeven inflation rates, we know that higher inflation expectations have accounted for almost two-thirds of the rise in 10-year interest rates since last summer. As of March 9, 10-year expected inflation was 2.21%, the highest it’s been since 2014. What does this mean for investors?
If rates continue rising due mostly to higher inflation expectations, bonds won’t be the only asset class to suffer. Stocks would also likely face several headwinds–including higher discount rates, higher expenses (e.g., interest, wages, materials), and slower growth from tighter monetary policy. Indeed, higher inflation would pose a significant risk to most investors’ portfolios.
In the short term, we believe that higher inflation is likely as supply chains remain strained from COVID-induced shocks (like production shutdowns, labor shortages, and dramatic shifts in demand) and $1.9 trillion of additional stimulus will boost demand. Additionally, consumers have accumulated a lot of savings over the last year, which will likely lead to increased spending as the economy reopens.
However, unless the federal government continues to pass large fiscal packages, it’s unlikely that the economy will overheat. We expect inflation will be constrained by the labor market, which still has a long road to recovery due to the number of jobs lost during the pandemic.
Because the future is far from certain, we recommend that investors contemplate several things. First, it’s important to consider multiple economic scenarios, even those deemed less likely. By holding a portfolio that’s diversified enough to navigate varying growth and inflation environments, we believe investors can increase the likelihood of achieving their financial goals. Second, it’s always important to factor in valuations. Though valuations can remain depressed or stretched for prolonged periods, different valuation levels present varying levels of opportunity and risk. Finally, it’s important to evaluate your investment horizon. Investors can help reduce risk by matching the duration of their investments to when they will need their money.
As valuations change and the likelihood of different economic outcomes shift, we’ll look to reposition our investment solutions to mitigate risk and capture opportunities. We believe this dynamic approach to asset allocation in conjunction with broad diversification will improve the odds of achieving our investment objectives.
If you need assistance and would like to talk to a Ronald Blue Trust advisor, please contact us at 800.987.2987 or email [email protected].