Interest rates, and more specifically, rising interest rates seem to be on everyone’s mind lately. That’s a bit unusual because while people generally find stocks to be interesting, no one ever wants to talk about the bond market. I’ve commented before that bonds are boring, especially the way we invest. The base case investment scenario is that you get a fairly low, pre-determined rate of return and your money back at the end of the term. That’s nowhere near as fun as tech IPOs, stocks with multi trillion-dollar market caps, and colorful stories about gun slinging CEOs.
However, the Federal Reserve just raised short-term interest rates and longer-term rates have risen as well. That’s not terribly unusual, but maybe because we have an important election in a couple months, the financial media is treating this as if it is unusual and dire.
Today’s ten-year Treasury yield is around 5.25%. It was just over 4.0% at the beginning of the year, and in the bond world, a 1.25% swing is actually quite large.
Rising interest rates are bad. They’re bad for stocks, they’re bad for bonds, they’re bad for real estate values, they’re bad for economic growth, and they can even lead to inflation on some items. That is part of why you’re hearing so much about interest rates lately.
Yet, interest rates don’t seem to be derailing the economy. Consumer spending, hiring, manufacturing activity, and business capital investment are all at least relatively strong. Consequently, the Bureau of Economic Analysis just revised first and second quarter GDP higher and the Atlanta Fed’s real time model of economic growth suggests the third quarter could grow around 5%.
How can that possibly be? There has been a loud chorus by mainstream economists that tariffs, the war in Iran, rising interest rates, AI job disruption, and a threatened global supply chain will all weigh on economic growth. Well, it is important to remember the old quip that God invented economists to make weathermen feel good about themselves. The accuracy of most economic forecasts, from economic journalists all the way up to Fed governors, is pretty appalling. The media eagerly parrots back these crystal ball prognostications as if they were preordained truth, but if you invested your money based on economic forecasts, you’d go broke.
Besides, think back to what your first mortgage rate was. Among this article’s likely audience, I suspect there are many who paid 12% to 14%. Mine was over 7%. The aberration isn’t what is happening today, but rather what we experienced the past five or so years when you could secure mortgages for 2% to 3%. Hang on to those if you have them, because we’ll probably never see them again.
That doesn’t mean the economy is doomed. We’ve had very long and strong economic expansions and bull markets for stocks with interest rates at or above today’s level. The dot.com boom is a perfect example. In fact, since 1962 the ten-year Treasury yield has averaged 5.8%. That’s higher than today, so even with the recent runup, we’re still below average.
Of course, interest rates could continue to move higher. At some point that could become an economic headwind, but it also creates opportunities.
Demographic trends, very high levels of government debt globally, demand for credit to fund the AI buildout, and an increasingly inward focus by foreign governments could all put continued upward pressure on interest rates. A more benign possibility is that interest rates move higher for a good reason: that economic growth continues at a strong and healthy rate.
Moreover, interest rates tend to move in 25 to 40-year cycles, and we almost certainly completed a 40-year downtrend during Covid when the ten-year Treasury bottomed out at 0.5%. Our friend and renowned technical analyst Louise Yamada has written about this, and it would not be surprising to see rates continue to rise for a long time, if not in a perfectly linear fashion.
At some level, which is unknowable, higher interest rates will make business investment impractical. And the AI buildout could put a large debt load on the most aggressive capital spenders, which could impair profitability. That would slow economic growth and likely bring stock market valuations down from today’s high levels.
However, thinking about portfolio construction could change. If long-term government bonds start paying 7% or more, it may make sense to shift more money there. Afterall, there is little risk of default with Treasuries, and you can lock in a guaranteed rate for 20 or 30 years just by buying long bonds. Those rates were over 15% in late 1981. There was also high inflation that made those rates look less attractive, but it would be awfully tempting to secure a 15% return for two to three decades “risk-free.”
It is premature to be thinking about that, but it is also premature to lose sleep worried about the bond market and the impact of interest rates on the strong US economy. We suspect a lot of the noise these days is fearmongering ahead of the election, and that things may feel at least a little more normal after November.
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Disclaimer: Armbruster Capital Management’s views as portrayed in this post are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security or sector. Investing involves risks, and the value of your investment will fluctuate over time, and you may gain or lose money. Past performance is no guarantee of future results.