The Facts

The 10-year U.S. Treasury bond bottomed in July 2016. Since then, the interest rate on the 10-year has more than doubled, rising from 1.39% to 2.9%.

At the same time, the Federal Reserve has increased short-term rates from 0.50% to 1.75%.

On March 21st, new Fed Chair Jerome Powell stated he expects two additional short-term rate hikes this year and likely three more next year, based on anticipated economic growth and continued low unemployment.

Rising rates

The bad

• Higher interest rates make borrowing more expensive.
  This increases monthly payments on loans such as mortgages and auto loans and can reduce housing affordability, potentially pushing home prices lower.
• Existing bonds purchased at lower interest rates decline in value.
  Investors are unwilling to pay the same price for a bond yielding 1.4% when new bonds are yielding 2.9%.

The good

• New investments in money market funds, CDs, and newly issued bonds offer higher yields.

However, this benefit is only realized if interest rates stabilize rather than continue rising.

What causes rising interest rates?

Market-driven factors

Economic data can push rates higher. For example, in February 2018, a government report showing rising wage growth increased inflation expectations, causing bond yields to rise.

Increased borrowing needs

Higher issuance of government and corporate debt can also pressure interest rates upward. If demand for new bonds is weak, issuers must offer higher yields to attract buyers.

Key drivers include:

• Recent tax legislation increasing U.S. budget deficits, requiring more Treasury issuance
• Approximately $1 trillion in corporate debt needing refinancing over the next three years

What causes inflation?

1. Low unemployment

A strong economy with low unemployment can lead to wage inflation. This effect may be amplified by demographic constraints and reduced labor supply. Higher wages are often passed on through higher prices for goods and services.

2. A weaker U.S. dollar

When the dollar declines relative to other currencies, imported goods become more expensive. This can contribute to broader inflation as domestic producers raise prices in response.

3. Rising commodity prices

Increases in commodities such as oil, copper, and lumber raise production costs. As global demand increases, these higher input costs are passed on to consumers.

4. Tariffs and trade policies

Tariffs function similarly to a weaker currency by increasing the cost of imported goods, allowing domestic producers to raise prices.

How rising rates and inflation affect your portfolio

Bonds

• Existing bonds purchased at lower yields decline in price as interest rates rise
• Fixed-income portfolios may struggle to keep pace with inflation, reducing real purchasing power
• The traditional role of bonds as a hedge against stock market declines may be weakened in a rising rate environment

Stocks

• Stock valuations are based on the present value of future earnings
• Higher interest rates increase the discount rate applied to those earnings, which can reduce stock valuations
• Rising bond yields also create competition for equities, as newly issued bonds become more attractive relative to stocks

So, what’s a prudent investor to do?

These are challenging times, with implied lower expected returns across traditional asset classes.

Investors may want to:

• Re-evaluate exposure to long-duration bonds
• Consider alternative asset allocations
• Review overall portfolio positioning in light of rising rates and inflation dynamics

This is an excellent time to reassess risk tolerance and ensure your asset allocation is appropriate for current market conditions.

Advisors who offer tactical asset allocation strategies can assist in this process.