What Rising Bond Yields Mean for Investors

Ivanna Hampton: The benchmark used for many mortgages and other loans has hit a high not seen since 2007. The U.S. Treasury 10-year note is hovering around 4.5%. And some market watchers are anticipating rates will stay so-called “higher for longer.” Here is Morningstar Inc.’s chief markets editor and Smart Investor newsletter editor Tom Lauricella to talk about that.

Thanks for joining me, Tom.

Tom Lauricella: Happy to be here.

Why Haven’t Bond Yields Fallen?

Hampton: Many investors expected bond yields to start falling around this time of year. Why hasn’t that happened?

Lauricella: Among the many surprises we’ve had in the markets this year, the bond market has been a big one. Many folks had expected a recession to be taking place right now for the economy to be rolling over. And along with that, there had been expectations that interest rates would be starting to come down, that the Fed might be on the verge of lowering rates, and the bond market in particular, that yields on bonds would also be falling along with the weakening economy. That is definitely not what’s been happening. It’s been a real surprise the degree to which the opposite has been the case. And bond yields have been rising to their highest level in a long time.

Key Factors Keeping Higher Bond Yields

Hampton: And you’ve written that there are three factors keeping bond yields higher. What are they?

Lauricella: The first of three is probably the most important, and that’s the actual underlying strength of the economy. As I said, many people had expected us to be sliding into a recession right now. Not only is that not happening, but there are signs that the economy has even gotten stronger in the third quarter. The Atlanta Fed has a measure of current GDP growth, their estimate, and that’s approaching 5%, which would be the strongest rate of growth since the end of 2021 and more than double what we saw in the second quarter. That’s a pretty remarkable pickup in economic growth for this point in the economic cycle and especially with the Fed having raised interest rates to such a large degree a year ago. So, the main thing is that the economy is strong, and the concern here is that that’s going to make it much harder for inflation to keep coming down toward the Fed’s 2% target. And that’s especially the case with a tight job market. We haven’t seen the job market softening up much at all. And as we’re seeing with some of this labor activity, contracts being produced that have big wage increases, the concern is that we end up with this cycle that keeps inflation from coming down. So, the economy has probably been the biggest surprise and is probably the biggest factor at play here.

Hampton: Tom, you mentioned the economy. What about the other two factors?

Lauricella: The second one is somewhat related to that, and that’s the Fed’s own estimates of where it’s going to be taking interest rates. People refer to that as the Fed’s dot plot. Essentially, what the dot plot is, is the forecast from individual Fed officials about where interest rates are expected to be next year. And what we saw at the most recent Fed meeting was that those expectations have risen. So, not only are expectations for Fed easing being put off, but in fact, it’s looking like the Fed itself doesn’t expect to take interest rates down that much. So, there’s an adjustment that takes place in the bond market. If the Fed is only going to be cutting interest rates by, say, 0.5% next year, that’s a very different story when it comes to the bond market than if the Fed was going to be cutting interest rates by 1.0%. Either way, the Fed was signaling—and that’s where this “higher for longer” idea comes from—the Fed is signaling that it expects to keep interest rates higher for a longer period of time.

The third one is a little bit different here, and this is one particular to the bond market, and that is the U.S. government is having to issue a lot more debt than people had expected just three, four, five months ago. And what that does is, it’s basic supply and demand. There’s a lot more supply. Demand is a little iffy right now with these concerns about the economy. And so, if the government is selling a lot more debt, then the market is going to start notching prices down to attract more buyers, and that drives yields up. And so, this is a factor that a lot of folks outside the bond market might not see, but it’s an important one when it comes to magnifying the impact of these other fundamental factors. So, those are the three things that are really responsible for why bond yields are rising right now.

Bond Market Impact on Growth Stocks

Hampton: And what’s been the impact on growth stocks?

Lauricella: Well, the growth stocks have run into a little stretch of mud here after having a really strong race higher in the first half of the year. Growth stocks are particularly sensitive to interest-rate expectations. These were the stocks that were leading the market rebound through July. Since then, as interest rates in the bond market have crept higher and moved higher more rapidly lately, we’ve seen the air come out of that move higher for these growth stocks. That’s been a big driver of what’s led the stock market to fall back.

What Does It Mean for Investors?

Hampton: And what does it mean for investors if interest rates stay higher for longer?

Lauricella: Well, this is what I think people are still digesting. The question is, how much higher? There’s some thought that perhaps, as you mentioned at the very beginning, they could still creep higher here, especially if the economy does not cool off. And how long? And at this point, it’s still anybody’s guess. But investors are not used to this kind of environment. It’s been over 15 years since we’ve been in what some people will call a normal interest-rate environment from before the great financial crisis. I think for a lot of investors, it requires thinking a little bit differently than they have and understanding that all the variables that come into play with higher rates, such as what happens in the housing market, the cost of financing for companies, and consumer debt generally. We’re going to be at a higher level, and a lot of the calculations that people have been making for the last decade-and-a-half might have to be tweaked.

Hampton: Thanks, Tom, for your time today.

Lauricella: Great to be here.

Hampton: Subscribe to the Smart Investor newsletter to read Tom’s weekly commentary and Morningstar insights on market trends. I’m Ivanna Hampton. Thanks for watching.