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Rising Rates and a Steeper Yield Curve

Interest rates have been on a rollercoaster ride this year. The 10-year Treasury yield was as high as 2.8% at the start of the year before falling below 1.5% only two months ago – the lowest level since 2016. It’s now risen almost half a percent to 1.94%. As a result of this rate volatility, the yield curve also inverted briefly earlier this year. What are interest rates telling us today, and why does this matter to everyday investors?

Interest rates matter to investors for many reasons. Most obviously, interest rates are directly related to the amount of income investors can expect to generate from their portfolios. As a measure of the “risk-free rate,” the yields on U.S. Treasuries represent a baseline level of interest that can be earned by investors across different maturities. Choosing to take on additional risk allows investors to potentially increase their yield above and beyond this risk-free rate.

Unfortunately for investors with large cash savings – especially those in or near retirement – interest rates have been quite low throughout this business cycle. Since 2012, the 10-year Treasury yield has only surpassed 3% during two short periods before falling back each time. This has made it extremely difficult to generate sufficient income from safer bonds alone.

One reason that interest rates have been so low for so long is that central banks such as the Federal Reserve have kept their policy rates low, and at times have even depressed rates further by buying financial assets. The fact that the economy has only been growing at a modest rate, even if it has been doing so steadily for a decade, means that central banks have continued to add stimulus measures. For those who depend on their portfolios and cash savings for income, this has meant taking more risk in order to generate sufficient yield.

But perhaps the more important reason that interest rates matter to investors is that they incorporate information about the economy. Specifically, the yield curve is a signal of where we are in the business cycle and of recession risk. Typically, the yield curve is very steep at the beginning of a cycle. This is because the Fed keeps short-term interest rates low during economic downturns to stimulate the economy. As growth picks up, long-term rates begin to rise, which steepens the yield curve. Eventually, however, growth slows or the Fed over-tightens, resulting in a flatter or inverted curve.

From that perspective, interest rates are providing both good news and bad news. The bad news is that rates continue to be low, making it difficult to generate income. The fact that the yield curve had inverted briefly a few months ago – i.e. long-term rates were below short-term ones – is also a classic signal of future recession.

The good news is that long-term interest rates have risen in recent weeks, resulting in a yield curve that is no longer inverted. Short-lived inversions have occurred in the past, including in the late 1990s, often due to global economic shocks. While recessions are an inevitable part of business cycles, a “re-steepening” of the yield curve often suggests there’s more time left in the cycle.

Either way, investors should continue to stay balanced in light of the swings in interest rates this year. All investors may, at least for the near term, benefit from the optimism that rising rates suggest about the world – and the all-time stock market highs that have come along with it.

Below are three charts that put recent interest rate moves in perspective.

1. Interest rates have risen in recent weeks

interest ratesInterest rates have recovered recently due to optimism around headlines such as U.S.-China trade and the U.S. economy. There are many forces affecting rates at the moment, including low international rates – especially in Europe – and slowing U.S. growth. However, increased investor optimism could push rates up further if there are breakthroughs in global issues.

2. The yield curve is no longer inverted

yield curveAs a result of both rising long-term rates and recent Fed rate cuts, the yield curve is no longer inverted.

3. Yields on cash are still low

income on cashWhile cash rates have increased, they are still quite low by historical standards. This is especially true after adjusting for inflation – the purchasing power of savers’ wealth continues to be eroded by low interest rates.

Source: Clearnomics

Mike Minter

As Chief Investment Officer, Mike directs the overall investment strategy, develops portfolio allocations, oversees trading and rebalancing, and conducts research and analysis. As a perpetual student of investing and the markets, Mike considers himself obsessed with the subject. He 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).   Read Mike’s Profile HereRead More Articles by Mike

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