Interest Rates are Higher, But Not High

Oct 6, 2023 – After 15 years of artificially low interest rates, today’s rates seem high in comparison. Yet in a wider historical context, interest rates are returning to normal levels. The yield on the 10-Year Treasury is moving closer to the benchmark’s historical average of 5.9% over the past 60 years. Additionally, the most recent Consumer Price Index (CPI) reading slowed to a 3.7% increase in prices for August over the year earlier. With the current 10-Year rate at 4.6%, the inflation-adjusted real yield is approaching 1%. This real yield has also returned to a more typical level after a period of low to negative inflation adjusted yields in recent years.

The transition back to more normal rates, as we have experienced over the past 18 months, is a needed but unpleasant process. In the short term, increasing rates have consequences for investors, borrowers, and lenders. Periods of increasing interest rates are a negative for stock prices. For companies that are priced on expectations for future years’ earning ability, higher rates make coming years’ profits less valuable today. For companies that routinely rely on debt financing, increased borrowing costs reduce profitability. Additionally, income investors previously attracted to dividend stocks now have a low-risk alternative in 5% Treasury securities. For bond investors it is even simpler: when market interest rates rise, the price of existing bonds declines to make their older, lower coupon payments competitive with higher coupon, newly issued bonds.

The biggest issuer of bonds in the U.S., the federal government, has seen and will continue to see net interest cost on the national debt rise significantly. This is a structural fiscal problem Congress would do well to address.

Nevertheless, the transition back to historically standard rates has advantages. Savers can now earn reasonable, risk-free interest on bank balances and investors can expect a worthwhile return when allocating money to bonds in a diversified portfolio.

Quality companies have, in the past, performed well in a mid-single digit interest rate world. Consider the stock market performance of the 80’s and 90’s, and even the 00’s prior to the 2008 – 2009 global financial crisis. Companies have the ability to adapt to conditions by adjusting their balance sheets and business models to maintain and grow profits. In addition, highly speculative, profitless companies—who in recent years found it easy to raise large amounts of ultra-cheap investor capital in an environment where risk free rates were near zero—will be required to become disciplined or will likely fail. In either scenario, investors in quality companies will benefit.

Given a choice between the artificially low rates of the past 15 years or the current move toward more normal rates, I would prefer the current rate environment once inflation is restrained, and the Fed has finished intervening for this cycle. Considering the pros and cons in a larger historical context, my view is that more sustainable, normal interest rates are healthy for the economy, for business, and especially for savers and stock and bond investors over time.

U.S. Stocks: Stock prices have fallen as longer-term interest rates climbed. The 10-Yr Treasury Note yield has risen from 3.8% at the end of the last quarter to 4.6% as of September 30^th. The sell-off that started late this summer has generally made U.S. stocks underpriced. Company profits are expected to have risen in the recent quarter which would make U.S. stocks an even better value. Company earnings reports and management’s forward guidance, set to be released in mid-October, will again be a considerable factor in the direction of U.S. stocks in upcoming months.

Foreign Stocks: Since mid-summer the U.S. Dollar has strengthened, reaching its highest level since last November. As a result, returns for foreign stocks are shrinking for U.S. investors. Despite this recent currency headwind, we continue to invest in foreign developed markets such as Europe and Japan with Japan being a bright spot. Among emerging market countries, those friendly to the U.S., such as India, may benefit from a reordering of the global supply chain.

Fixed income: Long-term interest rates climbed higher in the third quarter. When rates rise, the price of bonds decline. The 2-Year Treasury finished the quarter at 5.0% and the 10-Year at 4.6%. With a slowing economy, we continue to be cautious regarding credit quality, replacing lower quality positions with higher quality. We also take advantage of higher rates in intermediate and longer maturity bonds by extending the range of maturities in portfolios. We “ladder” portfolios of individual bonds with similar dollar amounts in each maturity from two years to seven years. We use tax-exempt municipal bonds in taxable accounts. For those in high tax brackets, these double-tax-free yields can equal an 8.5% taxable yield. In retirement accounts and other tax-free or tax-deferred accounts, we invest in CDs, treasuries, government agency bonds, and corporate bonds. For a short-term objective, we may hold money market funds for daily liquidity with yields above 5%. For portfolios with a timeline of a few months to a few years, short-term CDs and treasury securities—both with current yields in the low to mid-5% range—are suitable options.

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