As you may have noticed over the last week, interest rates are moving higher. It began with the Federal Reserve raising the level for its target benchmark to 2.00%-2.25%. This is the third rate hike by the Fed this year. They also signaled rates may rise again in December. Then over the last few days, the interest rate on the 10-Year US Treasury climbed to almost 3.25%. While rates are still historically low, we have not seen rates at this level since late 2010.
Most investors have the idea that interest rates/bonds and stocks move in opposite directions. And while there is some truth to that belief, as with most things, it is more complicated than that. There are two points I’d like to make about rising interest rates and their impact on both stocks and bonds.
First, rising rates don’t automatically spell doom for the stock market. This fact often gets lost in the incessant search for attention-grabbing headlines by the financial media. Interest rates initially begin to rise because the economy is improving, and that is a good thing for equities. Eventually, rates go too high and it begins to choke off economic growth. This is part of the economic cycle. The interest rate level where equities are affected has actually been pretty well-defined historically. The chart below from JP Morgan Asset Management shows weekly S&P 500 returns versus 10-year Treasury yields. When rates are low, the S&P 500 goes up when rates go up. The tipping point is pretty clearly defined by the orange line at 5.0%. The 10-year Treasury yield is at 3.20% right now, so we have quite a ways to go until we get to that 5.0% level. The current tightening cycle isn’t automatically a bad thing for equities and should not be used as an excuse to stay out of the market at these levels. We assume that a 10-year Treasury rate of 5% is historically the level at which investors might determine the risks associated with the fixed income market are more favorable than the risks of staying in the equities markets.
Second, rising interest rates can hurt the value of bonds, but rising interest rates do not change the amount of income that an existing bond produces. For clients that are using individual bonds (municipal or corporate) to generate income, those income levels won’t change. However, the value of the bonds within the portfolio can decrease (the value if you wanted to sell the bond). Such a decrease in value in turn puts pressure on the portfolio’s overall performance. Bond funds are more complicated and I am in the process of reviewing how we should handle bond funds and bond ETFs going forward. The vast majority of bond funds and bond ETFs clients own are “short term,” which offers a certain level of protection from rising rates. But there may be alternatives we may want to pursue. This is not a dire situation and will be addressed on a client-by-client basis.
I continue to believe that the market has more room to run. We are all enjoying a pick up in economic activity as a result of the changes to the tax laws and deregulation. Corporate profits are up significantly this year and therefore support a market at all-time highs. We are also moving into a seasonally strong period for the markets.
Please let me know if you have any questions or concerns or would like to schedule to discuss further.
