Staying high for longer

The U.S. economy is doing better than expected but is not the only one. GDP growth of 2% in Q1 was followed by 2.4% growth in Q2 and the Atlanta Fed GDPNow forecasting model currently suggests growth of 5.9% for the 3^rd quarter. The implication of this re-acceleration in U.S. GDP growth is that the U.S. Federal Reserve (Fed) will likely need to maintain interest rates at current high levels for an extended period to get inflation back to its 2% target. This has resulted in stock and bond markets globally running into some turbulence over the past couple of weeks as investors reprice expectations of central bank policy rates staying higher for longer. So, for instance, the benchmark 10-year U.S. treasury yield has jumped 38 basis points in August (August 21^st) despite inflation moderating to 3.2% in July from its 40-year peak of 9.1% in June 2022. Additionally, the benchmark S&P 500 equity index has retreated by almost 5% in August. 

However, it’s important to note that while market interest rates have moved higher than anticipated recently, this should not be viewed as a signal that the Fed will need to deliver a new round of policy tightening, but rather as a reflection of the current resiliency of U.S. economic growth. In fact, the current consensus view is that the Fed will pause in September, and effectively end its rate hiking campaign while holding its current policy rate of 5.25% - 5.5% for a prolonged period. Moreover, inflation has been moderating and the trend is expected to continue, although not in a perfectly straight line, so any further upward movement in longer term yields is not expected to be significant. And rightly so, the rise in longer-term rates has not been matched by a move higher in short-term rates. Therefore, the steepening of the U.S. yield curve in August (although remaining inverted- a recession indicator) can be viewed as a reflection of better growth as opposed to an expectation of more Fed rate hikes.

What are the ramifications for investors?

The potential impact of higher for longer interest rates on investors can be profound. As it relates to bond investors, bond prices and yields share an inverse relationship: when interest rates rise, existing bonds with lower yields become less attractive, leading to price declines. Investors holding these bonds might face capital losses if they choose to sell before maturity. Additionally, new bonds issued in a higher interest rate environment carry higher coupon payments, diluting the appeal of previously issued bonds. As the Fed leans towards "higher for longer," bond investors may need to reassess their portfolios, considering shorter-duration bonds or diversifying into other fixed-income assets less sensitive to interest rate fluctuations.

Equity investors, too, must reckon with the implications of prolonged higher interest rates. The relationship between interest rates and equities is nuanced. While rising interest rates can signal a strengthening economy, they also increase borrowing costs for businesses and impact consumer spending patterns. A resilient economy supported by a strong labour market and robust consumer spending could mitigate some of the negative effects of higher interest rates on corporate profitability. However, if borrowing costs become prohibitive, businesses might cut back on expansion plans, impacting potential earnings growth.

Another factor that equity investors should consider is the competition between stocks and bonds. In a low-interest-rate environment, equities often become more attractive due to their potential for higher returns. As interest rates rise and bond yields improve, some investors might shift their allocation away from equities toward fixed-income securities. This movement could lead to increased volatility in the stock market, as shifts in investor sentiment and capital flows impact equity prices.

In conclusion, a healthier than expected U.S. economy has led to a recent jump in long term U.S. yields. However, this can be viewed more as a reflection of the resiliency of U.S. economic growth and not an expectation of additional Fed rate hikes. While a higher for longer rate environment can be quite unnerving for both bond and equity investors in the near term, it also offers the potential for higher income through larger coupon payments for bond investors and possibly larger dividend payments for equity investors.

Eugene Stanley is the VP, Fixed Income & Foreign Exchange at Sterling Asset Management. Sterling provides financial advice and instruments in U.S. dollars and other hard currencies to the corporate, individual, and institutional investor. Visit our website at www.sterling.com.jm

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