Rising Rates: Good or Bad?

Rising Rates: Good or Bad?

Much of the recent investor unease has centered around rising interest rates. There are many ways to think about interest rates: as a tool for generating portfolio income, as an important factor in stock prices, as a signal for the business cycle, as a risk indicator for Fed policy, and more.

In many ways, rising interest rates from such low levels is positive for investors. Since the financial crisis, one of the biggest challenges investors have faced has been the search for yield. For most of this expansion, slow global economic growth resulted in few opportunities to generate sufficient portfolio income. Investors have been forced to reach for yield in assets ranging from dividend stocks, REITs, MLPs, to high yield debt.

While short-term interest rates are now at their highest levels this business cycle, long-term interest rates matter more to most clients. While long rates have certainly jumped, they are still low by historical standards. The 10-year Treasury yield has climbed to only 2.88% – the last time it hit 3% was back in 2013. Meanwhile, the 30-year yield is only 3.16% – barely higher than where it was one year ago. With inflation around 2%, the real, inflation-adjusted income that this generates is still meager.

Thus, while interest rates are rising, especially for cash, long-term rates are still near historically low levels. This means investors will continue to face difficulty meeting long-term income needs if they are only focusing on high quality core bonds such as Treasuries and investment grade corporate issues.

Using high dividend-yielding stocks for income certainly has worked in recent years due to the out-performance of U.S. stocks, but this approach is fraught with danger. At the end of the day, a stock is a stock. They can be extremely volatile and there is no guarantee a company will continue to pay its shareholders the same dividend over time. Just ask General Electric (GE) shareholders. GE’s share price has cratered and they slashed their dividend in half. There is no free lunch.

Thus, the search for yield continues with no easy solutions. The best approach is to maintain a well diversified portfolio.

1. Interest rates are rising but are still historically low

interest rates

Interest rates have risen this year, but not all at the same pace. While the 2-year Treasury yield is at a cycle high of 2.25%, the highest since Lehman Brothers collapsed, the 10-year is still stuck below 3%. It hasn’t been above 3% since the “taper tantrum” in 2013 when the Fed announced that it would wind down its quantitative easing policy. Even if long-term rates continue to rise, which we expect due to economic growth and inflation, it will be some time before it’s close to historical averages.

Rising rates are also a sign that we’re later in the business cycle. This has driven investor nervousness: the Fed may need to react to inflation by raising rates more quickly.

2. The Fed’s path is uncertain

fed funds rateThe Fed has hiked rates cautiously since late 2015. The federal funds rate has been increased five times, from 0% to 1.25%. Before that, it had been stuck at the zero lower bound for seven years.

Still, this is a much slower pace than in past economic cycles. During the last cycle, the Fed raised rates at 17 consecutive meetings from 2004 to 2006. This measured pace may have been too slow in hindsight as the housing bubble expanded, but provided consistency and predictability for investors.

Investors are nervous that rising inflation may require the Fed to move more quickly, and this is compounded by uncertainty due to the recent change in leadership at the Fed.

While these are real risks, we are also quite early in the tightening cycle. For now, the reason the Fed is raising rates is clear: because the economy is healthy.

 

3. Bond yields have increased somewhat

corporate bond yieldsRising rates and market volatility have pushed bond yields higher… somewhat. Yields are still near their lowest levels of the past several years – well below levels seen two years ago when oil prices collapsed.

What does all this mean? There is no right or wrong answer. Interest rates are moving up because the economy is healthy and strengthening. There are certainly positive impacts from this, as well as painful ones. The market continues to adjust and adapt to this new environment. It will take time, but as always, the market will find a way to continue upward.

Mike Minter

Mike Minter

Mike develops investment portfolio allocations, handles trading and rebalancing, and conducts research and analysis as a Portfolio Manager and Financial Advisor for the firm. As a perpetual student of investing and the markets, Mike considers himself obsessed with the subject. Mike has earned the CERTIFIED FINANCIAL PLANNER™ (CFP®) and Certified Fund Specialist® designations. He is also an active member of the Houston chapter of the Financial Planning Association (FPA).

 
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