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Rising Rates, Political Turmoil Drag on Markets: Interest Rate Deep Dive Thumbnail

Rising Rates, Political Turmoil Drag on Markets: Interest Rate Deep Dive

Rising Rates, Political Turmoil Drag on Markets: Interest Rate Deep Dive

 

World equity markets experienced strong selling pressure yesterday as yield curves steepen across the globe and market fear relating to the debt ceiling comes to the forefront. 10-year U.S. Treasury yields have risen from 1.18% to 1.53% in under two months and are up from 1.32% just a week ago. 

Equities traded in lockstep with interest rates. The S&P 500 closed down 2.04% and has lost almost 4% the last month. The NASDAQ, composed mostly of longer duration, interest-rate sensitive equities felt more pain, down over 2.8% on the day and has lost over 4.5% the last month. European stocks behaved in a similar fashion with most European equity indices losing well over 2%. Asian shares are outperforming with Chinese equities up for the day while Japanese, Indian, and South Korean stocks trade modestly lower. Equity markets across the globe look to rebound today. 

Let’s first address the debt ceiling that’s been garnering headlines over the last week. In simple terms, the debt ceiling refers to how much debt the U.S. government can have outstanding. As a government, we’re nearing that limit and Congress has to vote in favor of an increase in order to raise the ceiling. The ceiling needs to be raised so the government can meet debt obligations. Since the U.S. runs budget deficits, we must borrow money to meet certain liabilities. If we can’t borrow, we can’t pay. If we can’t pay, we default. A default would certainly have a negative effect on markets and our government. It would likely increase the cost of borrowing for the country, it could shut down certain parts of the government, and could delay transfer payments like Social Security, Medicare, etc. It could also affect our credit rating and our strong financial standing in the world.  

However, the debt ceiling has been extended or suspended 98 times since its inception in 1917. It happened three times under President Trump. It happened in 2011 and 2013, which did cause temporary government shutdowns. In short, we’ve been here before. Policymakers are aware of how crucial it is we are able to meet our debt obligations and fund the government. Because of this, we should expect a resolution or suspension (which would extend the ceiling deadline). Treasury Secretary Janet Yellen has said the U.S. would essentially run out of money to pay its bills if a resolution is not reached by October 18th. We wouldn’t advise investors to take any portfolio actions around the potential for a U.S. default, but they should be aware of the potential consequences should the worst-case scenario play out and decide for themselves on whether or not to act. 

Daily headlines exhibit the multitude of economic, political, and geopolitical unknowns that investors have to digest. What complicates things further is not a single one gives a clear direction forward. Below we will examine one key factor the market focused on yesterday and investors should monitor closely: interest rates. With the Federal Reserve signaling a tightening monetary policy stance and economic growth projected to continue on a strong course, it’s crucial to know how the bond market affects your portfolio. 

How Rising Rates Affect Bondholders

Rising interest rates create negative returns for current bondholders, all other things equal. Longer bonds are more sensitive to changes in rates than shorter-term bonds. Why? Say you hold a 2 year bond and a 30 year bond. If rates rise, you can now get higher coupon payments in the open market than you can get with your current bonds. The result: the prices of your bonds have to drop because others aren’t willing to pay as much for those lower coupons. As the price drops, the yield increases. As a buyer then, are you likely to accept the lower coupon on the 2 year or the 30 year bond, or put another way, do you want lower interest payments for 2 years or 30 years? Probably, 2 years – thus, as the seller you’d have to lower your price even more on the 30 year bond compared to the 2 year bond to find a buyer willing to accept the low coupons for 30 years. This is duration, and why long bonds are more sensitive to rate movements. Duration can measure how sensitive your bonds are to movements in interest rates – for the most part, long bonds have higher duration and short bonds have lower duration. The trade-off is you are likely to receive a lower yield in short bonds vs. long bonds. 

How Rising Rates Affect Equities – Know What You Own and its Relation to Interest Rates  

Rising rates are also headwinds to high-growth stocks; why? High-growth stocks are longer in duration – when you buy a high-growth stock, you’re paying for all the company’s future growth today, and that growth is extended far out into the future, making its price today more susceptible to changes in future economic conditions. The opposite is true of dividend-paying stocks or value stocks – the majority of their value is reflected in dividend payments and near-term cash flows – in essence, they are less sensitive to higher interest rates and future economic conditions.

What Causes Interest Rates to Change?

In short, the Federal Reserve and a country’s monetary policy drives short-term rates while long-term rates are more driven by economic forces, mainly supply and demand. Let’s look at long-term rates as those are what rose the most yesterday. As economic growth increases or looks favorable, investors are more likely to sell their bonds and buy equities in the hope equities will provide a better return. As investors sell bonds, bonds prices drop, and yields rise. Similarly, as inflation increases, or more importantly the expectation of inflation increases, the real value of your current coupon payments deteriorates – i.e., receiving a fixed dollar amount in coupons each month is less and less valuable as inflation rises. So, bondholders expect to receive a higher coupon for that uncertainty in future inflation levels. Again, this can lead to selling of current bonds, driving yields higher. 

Enough With the Lessons; What’s Happening Right Now? 

In September, we’ve seen yields of all maturities rise. The 10 year U.S. Treasury yield, which is often referenced as an interest rate benchmark, has risen from 1.28% to 1.53%, or about 20% in total. This could be from elevated inflation levels that investors don’t see waning anytime soon with all the supply-chain issues seen around the world. It could be from markets realizing the resurgence in COVID cases the Delta variant has caused may soon be peaking and strong economic growth will resume. In relation, it could be from investors believing the Federal Reserve will have to soon raise interest rates to stem the tide of inflation and have to cease the excess emergency relief money they have been pouring into the system for the past 18 months. It’s likely some combination of all of these and perhaps some other factors not mentioned. The below yield curve may be helpful to reference as we finish this discussion. 

 


With what we’ve laid out on bonds, equities, and interest rates herein we should have seen high-growth stocks suffer more than value-oriented stocks and long bonds suffer more than short bonds. The first column in the table below shows that is exactly what happened. This is eerily similar to what happened just earlier this year. From early February through the end of March, the 10 year U.S. Treasury yield spiked from 1.07% on February 2nd to 1.75% on March 31st. If you recall, this period was the beginning of the vaccination rollouts and a hope for a “return to normal” by summer. The expectation for future economic growth caused a massive spike in yields and economically-sensitive, value-oriented sectors outperformed by a wide margin.

Simple, right? If you know interest rates are going up, buy short bonds and buy value stocks. This is where the importance of diversification comes in. After bond yields reached 1.75% at the end of March, concerns over the Delta variant and supply chain issues began creeping into the economic landscape. From April 1st to August 30th, this hesitancy and concern caused the 10 year U.S. Treasury yield to drop from 1.68% to 1.29% as investors piled back into bonds. The value stocks you bought when rates went up performed okay, but far lagged the growth stocks. The short bonds you bought went essentially nowhere while the long bonds gained more than your value stocks did. In summary, interest rates are hard to predict over long time periods, and even harder over short periods. 

U.S. Equity and Bond Returns During Interest Rate Change Periods - 2021  8/31-9/272/2-3/314/1-8/3010 Year Treasury Yield Change (Interest Rate Change)0.25%0.68%-0.39%EquitiesNASDAQ 100 (Growth stocks)-2.52%-1.04%19.55%S&P 500 (Mixed Stocks)-1.79%5.56%14.65%Dow Jones Industrial Average (Value stocks)-1.34%9.61%8.13%BondsBloomberg 1-3 Year US Treasury Index (Short Bonds)-0.15%-0.09%0.13%Bloomberg US Aggregate Bond Index (Intermediate Bonds)-0.72%-2.72%2.90%Bloomberg Long Term US Treasury Index (Long Bonds)-2.14%-10.36%10.69%

The data we’ve laid out herein demonstrate the benefits to diversification. Interest rate movements are extremely difficult to predict, but their movements can have major effects on your portfolio. There are certainly other very material factors affecting equity and debt markets. We’re aware of the slowing projections of economic growth, the continued headwinds supply chain bottlenecks are creating around the globe, the impending Federal Reserve policy moves, the Congressional proposals that could send even more money into the economy and change tax laws, the stretched valuations of U.S. equities compared to international equities, and the threat of prolonged elevated inflation levels. These are all important topics that may warrant their own discussion, but today is all about rates (and the debt ceiling, begrudgingly). Interest rate movements have the ability to shake markets and understanding their role in equity and bond investing is a helpful tool for all investors. Like always, the most important portfolio decisions you can make are to remain diversified, patient, and invested. Please reach out to our team if you’d like to discuss any investment or financial planning topic you have questions on.