What Happens When Interest Rates Rise? 

Interest rates are forefront on investors minds as the pace of rate increases over the last several months is something not seen in decades. Interest rates determine the cost of capital in an economy and subsequently have an outsized impact on the trajectory of economic growth. What does the recent sharp increase in rates mean for the economy and potentially markets moving forward?

For the last 40 years interest rates have broadly moved in one direction: lower. In 1981 the yield (interest rate) on the 10-year US Treasury note reached 15.84%. By the summer of 2020 in the throes of the pandemic, the 10-year yield reached a nadir of 0.52%, a decline of nearly 97%. To help illustrate the enormity of this change we can look at the cost to service a traditional 30-year mortgage at both extremes. 

10-year US Treasury Yield (monthly chart – 1975 to present)

A $100,000 home purchased with a conventional mortgage, 20% down, and an interest rate of 17.84% would require monthly principal and interest payments of $1,195. A $400,000 home purchased with a conventional mortgage, 20% down, and an interest rate of 2.52% would require monthly principal and interest payments of $1,268. The change in interest rates is responsible for a nearly 400% increase in the value of a home by persistently over 40 years reducing the cost to service the principal and interest of a 30-year conventional mortgage. Interest rates have acted as a gale force tailwind to the value of all assets over the last four decades. 

The yield on the 10-year US Treasury note is used as a proxy for fixed rate US mortgages as the assumed duration of a 30-year mortgage (before payoff or default) in the US is approximately 7 years. The closest Treasury security in duration is therefore the 10-year note. The interest rate spread between the 10-year Treasury and conforming/conventional mortgages has historically been approximately 2%. To keep the illustration simple, we’ll look at the principal and interest of mortgages with rates of 17.84% and 2.52% which include the spreads between the 10-year at the extremes of the past 40 years. 

However, since the nadir in the summer of 2020, the 10-year yield has risen from 0.52% to 2.38%, an increase of over 450% in just over 18 months. Yields have only accelerated the speed of increases in 2022 on the short end of the yield curve as inflation shows little sign of slowing. In fact, short term yields (2-year and 3-year treasuries) are higher than long-term yields (30-year Treasury Bonds) for the first time since the brief, but steep, recession experienced at the onset of the pandemic in 2020. When at least one longer dated maturity has a lower yield than a shorter dated maturity this is known as an inverted yield curve. In normal times, longer dated maturities should have higher yields to compensate for the longer time and therefore greater risk to the return of one’s capital. An inverted yield tends to occur when investors expect heightened volatility or headwinds to growth.

US Treasury Active Yield Curve 

The current environment would lead one to believe that the Federal Reserve’s tightening of economic conditions thru raising short term interest rates (the Fed Funds Rate) has the potential to cause a recession. An inverted yield curve has preceded every recession since 1956.

With inflation running hot and interest rates historically low, there is a significant gap between inflation as measured by the Consumer Price Index (CPI) and the Fed Funds rate demonstrating that interest rates may have much further to rise. CPI year over year is registering at 7.87% versus the current Fed Funds rate of 0.50% leaving a spread of 7.37%, a 50-year high. The last time the US economy experienced spreads of only 5% was in the early 70s and early 80s when inflation was rampant, and the Federal Reserve raised rates in a dramatic fashion. 

CPI Index (year over year) & Fed Funds Target Rate (quarterly chart – 50 years) – top chart

Spread between CPI Index (year over year) & Fed Funds Target Rate (quarterly chart – 50 years) – bottom chart

The Federal Reserve has a near impossible task on their hands of slowing inflation through raising interest rates while simultaneously not sending the economy into a recession. Further exacerbating the current environment is the war in Ukraine and supply chain issues remaining from the pandemic. Some economists speak of the opportunity for a “soft landing” and the Federal Reserve being able to successfully navigate a negative outcome. We see substantial risks going forward as the extreme asset valuations due to historically low interest rates have the potential to reverse course and destabilize asset prices. In addition, heightened inflationary environments benefit commodities above all other asset classes, a segment of the markets where most investors have little to no exposure. Investment returns in this new environment will likely take cues from the 1970s requiring a major overhaul to the 60/40 portfolio of today.