The WHY and the WHAT of Rising Interest Rates
It’s nearly impossible to miss the news of rising 10-year treasury note yields. What is easier to miss is the explanation of why the yields are increasing so rapidly and what that means to us as investors.
Let’s start with the WHY. As the economy starts to recover, there is an increasing expectation of inflation. As the risk of inflation increases, interest rates are pushed higher. Despite the resulting what we hope will be short-term volatility and pain, there are definitely positives and negatives for rising interest rates as we think about our portfolios. Regardless, we should keep the rising interest rates in perspective. Today’s 1.5% treasury yield seems so high, but it’s still close to the recent era historic low – well below where it was two years ago. It’s the rapid rise from about 1% at the start of 2021 to the current level which is creating the angst. I’m old enough to remember Jerome Powell saying that the Fed has no immediate plans to raise its benchmark interest rate or to reduce its bond purchases, but clearly investors are not as sure as he seems to be.
Now let’s look at happens when interest rates increase. The most obvious result is that bond prices go down. You can see that in your treasury notes and in your bond funds. Short term bond funds, which many of you own as a back-up cash reserve, have definitely been impacted, but less so than the bond funds which hold longer duration bonds. Of course, the monthly interest payable on all bonds will also increase, but that will take a moment to happen and even longer for us to see it.
The less obvious result is that most equity prices have also dropped rather precipitously in the last few weeks. The exception has been “economic re-opening” companies (think Disney) which have taken a beating in the last year. Many of these re-opening companies are in the Dow which is why the Dow has so greatly outperformed the tech-heavy NASDAQ in the last few weeks. Big picture, what is happening is that as interest rates increase, we as investors look hard at the equities in our portfolios and often decide that the risk premium associated with already very high-priced equities just isn’t worth it right now, because we can get an improved return on a presumably safer bond investment. Tech has been particularly hard hit because the prices in the last year have increased significantly. Think Apple, Microsoft, Tesla.
The observation that bond and equity prices have come off their highs while the economy is improving so quickly is certainly disconcerting, but history and economics suggest that this can be a relatively short term reset. We all hope.
So now the obvious question is “you said there is good news, where is that part again?”
Some industries do better with rising interest rates. Banks for example can do well because they make higher profits on loans. Bank and financial services companies have been good this month so far. Some energy companies have also done well because oil prices tend to go up with inflation. So those of us that held onto those Exxon shares through what was a terrible 2020 might be feeling a little better. For now.
Our cash reserves in those high yield savings accounts or short term bond funds will eventually deliver a better return. Might be almost time to look for those coffee cans of $10 bills buried in the back yard. It’s about time.
Many of us own TIPs which are adjusted twice per year for inflation. There hasn’t been much movement in these over the last 18 months but if the current trends continue, it is likely that there will be a bump in the principal value of the existing issues in July and newly issued TIPs will be at higher coupon rates. All good here.
Bottom line, stay the course and remember why we have these diversified portfolios.