26Mar

RISING INTEREST RATES; IMPACT ON BONDS

After lots of speculation the last couple of years, interest rates have begun a slow climb out of the cellar, thanks to a more robust economy. It is a double-edged sword in many ways, with borrowing costs going up as economic stimulus simultaneously accelerates.
The Federal Reserve, under its new chairman Jerome Powell, has its eye keenly focused on the low unemployment rate and the threat of encroaching inflation. After near zero interest rates for years, these factors are forcing their hand.

Chairman Powell’s recent remarks before the House Financial Services Committee were encouraging in terms of the economy and its direction, but that is where that double-edged sword can be found. This good news means that the Fed can see the prospect of increasing inflation and their answer is to raise interest rates. An overheated economy, means that the pace of rate increases has to increase, and that increases the risk of a recession, although slight.

The chairman indicated that four rate hikes may be in the offing instead of the planned three this year.

The factors that are prompting the Fed’s new optimistic assessment include strength in the labor market, more stimulative fiscal policy and continued strength globally. The central bank’s inflation goal is two percent.

The Fed’s next meeting is in late March, when officials might firm up their estimate of rate increases for the year. Many investors also anticipate another rate hike coming out of this meeting. Some analysts also forecast three rate hikes next year.

Bond Yields

Consumer inflation, which hasn’t been a concern in several years, has re-entered the picture with the more vigorous economy. Retail sales were off in January. Early February showed core inflation at 1.8 percent year over year.

Recently, we saw an increase in yields on the 10-year Treasury note. The price of existing bonds have fallen, sending yields higher. Those yields have been close to three percent recently. This can have an impact on the stock market as investors can be lured away from dividend-paying stocks to bonds.

Shorter term bonds usually see a decrease in demand as rates increase. Prices come down and yields go up. The impact of rate hikes on the longer 30-year bond (inflation protected) are not impacted as much. There is a merging though of the yields on the shorter-term bonds and the long bond.

While bond yields have become more attractive, the stock market continues to captivate investor interest, albeit, with more volatility. Rising interest rates can help regional bank stocks.

The stock market’s performance, going forward, and the Fed’s decisions will both determine how much interest bonds receive in the near future. All eyes are on the Fed to see if their decisions have already been priced into the stock market.


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