Are interest rates the fly headed for the ointment?

Stocks set new highs again last week with a myriad of factors grabbing a piece of the spotlight, including Congressional hearings aimed at deciphering the recent GameStop trading frenzy, ongoing Washington negotiations over the details of the coming fiscal-aid package, and incoming data that continue to paint a picture of an economy that is enduring lockdown headwinds but is also primed for a jump amid rising vaccinations.

But what caught our, and the market's, eye was the upward move in interest rates. A 10-year Treasury yield of 1.3% may feel like a nonstory, but the recent move higher in longer-term rates is unlikely to proceed unnoticed, both for the reasons behind the increase as well as the implications higher rates pose to the market's path ahead1

The bottom line: The fundamental outlook remains quite favorable, and the market's high degree of optimism is not misplaced, in our view. We don't think interest rates will be the fly in the recovery ointment this year, but we do think higher rates could represent a catalyst that could temporarily clip at the wings of what has been a steady flight higher for stocks. With the rate story set to get more attention, here are four key takeaways:

  1. Rates are rising for a reason, and not a bad one.
  • Five-year inflation expectations have more than doubled from last year's low and are now near the highest level since 20131. This, in part, reflects the comparison to this period a year ago when prices dropped as demand collapsed amid the pandemic lockdown. But higher inflation expectations also signal the anticipation of the rebound in economic activity.
  • Last week's retail-sales report showed spending increased by 5.8% in January versus the year prior1. This was the strongest reading since last fall and nearly triple the gain of two months prior. We suspect this was partly the result of the latest round of stimulus checks, and renewed lockdowns in February will likely show up in the next report. Nevertheless, we think this is an indication of the pent-up consumer demand and savings that will power household consumption later this year, supporting above-average GDP growth ahead.
  • We think any spike in inflation will prove temporary, but the recent rise in interest rates that has been driven by higher expected inflation, and by potentially less Fed stimulus on the horizon, is underpinned by our view that those two factors are a function of an economy that's gaining traction. 
  1. "Higher" rates are not the same as "high" rates.
  • Ten-year rates rose nearly a fifth of a percent last week and have now doubled from just last September.  While that trajectory may feel abrupt, it should not be lost that this brings 10-year interest rates back to where they were last February. Excluding the past year, the yield in 10-year Treasuries is still at the lowest level in history.  
  • Importantly, we don't think rates are at or nearing the level that would choke off economic growth. In fact, before the pandemic, there were no recessions in the post-war era that began when 10-year rates were even as high as 3%.  And historically, 10-year interest rates averaged 6.7% at prior stock-market peaks.

Long-term Rates Have Risen but Remain Historically Low

  Ten year treasury rate performance chart.

Source: Bloomberg

The above graph illustrates the 10-Year US Treasury Rate Yields starting in February 2000 and running through Feb,2021. The graph shows a general trend of declining yields, but showing a sharp increase in recent weeks. 

  1. Rising rates are likely to be a risk for the next recession or bear market, but not now, and not like this.
  • Economic expansions often end at the hands of punitively high interest rates.  Bull markets almost exclusively end at the hands of recessions (1966 and 1987 being the exceptions)1. We think this expansion could find its exhaustion point on the path of rising rates, but there is a key distinction that suggests we are still a long way from reaching that point.
  • That distinction lies not simply in the fact that rates are rising, but in HOW rates are rising. Prior expansionary phases met their demise as the Federal Reserve tightened monetary-policy conditions to levels that choked off economic growth (to suppress higher inflation). This involves the Fed hiking its short-term policy rate, in turn putting upward pressure on longer-term rates, which more directly dictate borrowing costs for consumers and businesses. 
  • Currently, longer-term rates have risen, but the Fed policy rate has not.  In fact, we don't expect the Fed to raise short-term rates for some time. So, what we're currently experiencing is higher long-term rates but not a commensurate move in short-term rates – a move known as "yield-curve steepening."  Curve steepening is most often associated with the early and middle phases of an economic expansion.  It's when the Fed starts raising short-term rates more aggressively that the curve begins to flatten, a trend more commonly found in the latter stages of the cycle.
  1. Rates could be the spark that lights a new bout of volatility.
  • Fundamental conditions remain categorically positive, in our view. The economy looks set to accelerate this year as the vaccine unleashes pent-up demand and unlocks the next phase of labor-market improvement.  Built on that foundation is the expectation for better than 20% corporate-earnings growth this year, helping validate the recent rally. And the combo of additional fiscal and monetary policy should keep a wind at the economy's back as we progress this year.
  • This many hash marks in the "pros" column does support our confidence in the broader outlook; however, it doesn't mean the "cons" column remains empty.  The market has risen 74% in the last 11 months, with relatively few setbacks along the way1. With sentiment quite positive, expectations high, and stock-market valuations above average, we think the market may periodically look for reasons to take a breather. The GameStop frenzy represented such a catalyst a few weeks ago, and higher rates could be another spark for temporary volatility. 
  • In 2013, the stock market fell 6% in reaction to the Fed signaling that it intended to pare back its bond-buying stimulus (referred to as the "taper tantrum")1. This occurred within the context of a strong market in which stocks gained more than 30% in 2013, but highlights the sensitivity the market will likely exhibit as the prospects of reduced Fed stimulus increase. We'd note that it was more than two years later before the Fed began raising its policy rate.  
  • Investors should anticipate periodic setbacks as the market progresses. But with economic, policy and corporate financial conditions still aligned to the earlier stages of the business cycle, we think increases in rates from recent historic lows represent a short-term risk to the current rally, not a more structural threat to the broader expansion. 

Craig Fehr, CFA
Investment Strategist

Source: 1. Bloomberg

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Source: FactSet, 02/19/2021. *Source: Morningstar, 2/22/2021. Bonds represented by the iShares Core U.S. Aggregate Bond ETF. Past performance does not guarantee future results.

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