Why are rates going UP if inflation is going DOWN?

You may have heard that interest rates are soaring, causing the stock market to fall. The S&P 500 fell 10% since its July peak, and the 10-year Treasury rate has surged from below 4% to above 4.9%.

Oddly enough, this hike in the 10-year Treasury rate coincides with flat inflation and the Federal Reserve electing not to increase the Fed Funds rate. So, what exactly is driving the 10-year Treasury rate upward?

One view is that traders are pushing the 10-year rate up because they expect the Fed to keep rates higher for longer. Since the Fed rate is 5.50%, traders are demanding higher rates for a 10-year bond. While that is certainly part of the narrative, I don’t believe it’s the entire story.

Instead, I think the heightened 10-year Treasury rate mirrors a shift in economic growth outlook. Let's refresh our understanding of what the 10-year Treasury rate symbolizes:

10-year Treasury Rate = Expected Inflation + Expected Economic Growth

Fundamental economic theory teaches that long-term interest rates mirror market sentiments about projected inflation and growth. The inflation expectation for the next decade has remained entirely stable at approximately 2.30% for the past year. Thus, the higher rates likely reflect increased optimism regarding long-term growth rates.

Market projections of future growth appear to have grown from approximately 1.70% to more than 2.60%. This 2.60% real growth rate aligns closely with the average real GDP growth between 2010 and 2019, a decade devoid of any recession in the US. Could this higher rate be suggesting that markets don’t expect a near-term recession? If so, then now would be a great time to buy equities while they’re at a discount.

However, if the market prediction turns out to be incorrect and we're heading towards a recession in 2024, both interest rates and stock market values could decline. In such a scenario, bonds in your investment portfolio would gain value as interest rates decrease. That’s why I often recommend maintaining at least 10% to 20% of your investment portfolio in bonds, even with a long-term strategy in mind. This proportion of bonds in your portfolio offers you the flexibility to invest in stocks should a recession occur.

We hope this article provides some clarity on the current market dynamics. As always, remember that this article isn't a substitute for personalized financial advice. Please contact a financial advisor to discuss suitable strategies for your specific circumstances.