With financial markets recovering due to economic optimism, reduced political uncertainty, and the rollout of COVID-19 vaccines, interest rates have also increased. The 10-year Treasury yield recently crossed 1% for the first time since last March when the pandemic reached the US, after falling as low as half of 1% in the summer. Despite this, rates are still near 40-year lows due to long-term macroeconomic trends. What signals are interest rates sending today and what should investors expect?
Interest rates reflect the health of the economy and financial system
Interest rates play many roles in our lives. We usually think about the interest rates on our savings accounts and loans. But they also provide important signals of the health of the economy and financial system.
There are a few ways to think about this. On a theoretical level, interest rates reflect expected GDP growth and inflation. If the economy is expected to grow quickly, and/or inflation is expected to pick up, this should also push interest rates higher. If consumers and businesses are optimistic about the future, borrowers may accept and lenders may require a higher “price” (a higher interest rate) for capital, whether for buying a house, starting a business, or building a factory.
On a more practical level, investors tend to buy Treasuries and other “safer” bonds during times of economic and financial stress. This increases the prices of these bonds which in turn lowers their yields. The opposite is true when there is economic and market optimism — bond prices will tend to fall as investors buy riskier assets, which pushes rates up.
All told, the rise in long-term interest rates since last summer reflects the same factors that have boosted the stock market. There is greater economic optimism since businesses began to reopen following the nationwide shutdown, there is less uncertainty following the presidential election and inauguration, and COVID-19 vaccines are being distributed across the US. Although many people continue to struggle with pandemic restrictions, the financial markets seem to no longer be in crisis mode. Thus, it is not surprising that rates may slowly return to pre-pandemic levels if the recovery stays on course.
Interest rates have been declining for decades
Although interest rates have recovered from last year’s lows, they have been declining steadily for nearly 40 years.
Sources: Clearnomics, Federal Reserve
There have been periodic spikes in interest rates over the past decade. This happened in 2013 when the Fed announced its “tapering” program to begin shrinking its asset purchases. Today, the Fed’s balance sheet has instead grown by an additional $3 trillion. This also occurred after the 2016 presidential election, partly due to reduced political uncertainty and partly to expected pro-growth policies. In both episodes, the 10-year yield rose above 3% briefly before falling again.
Interest rates can decline regardless of economic crises
It’s also important to keep the broader historical context in mind. Interest rates have been declining since the late 1970s for a variety of reasons that have nothing to do with short-term crises. Technology, globalization, worldwide cash savings, and other factors have conspired to push interest rates lower decade after decade. These effects pre-date the pandemic and even the 2008 financial crisis. The fact that the Fed responded to these emergencies with extraordinary monetary policy, alongside other central banks, has only magnified their impact.
Thus, despite recent interest rate movements, investors ought to stay balanced when considering long-term rates. While it’s positive that the economic and market recoveries have pushed rates higher, they are still near multi-decade lows. For borrowers and homeowners, mortgage rates remain very attractive. At the moment, the average 30-year fixed mortgage rate is hovering around 2.8% — around the lowest on record.
For savers, the challenge of generating sufficient income from cash and high-quality bonds will likely continue. This potentially means that finding alternative sources of income, from high-yield bonds to dividend-paying stocks, is still as important as it has been since 2008.
Prepare for your future with a balanced, personalized portfolio
As interest rate trends change, you can stay aligned with your investment goals with a balanced, personalized portfolio. Whether you prefer a consistent investment income with minimal exposure to market fluctuation, high potential risk/high gain equity-only portfolio, or something in between, you can find a portfolio that aligns with your risk comfort zone and personal preferences.
