Weekly Update

Interest Rates: Getting Back to Normal

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Published February 26, 2021


Interest rates have ripped higher along with stocks as expectations for a very strong post-pandemic economic recovery gain traction. This week, however, that rise in rates appeared to reach a point where concerns crept in. Stocks tumbled as investors worried that the rise in rates was too high, too fast. The long-term interest rate chart below tells us that the rise in rates, though sharp, has only recovered the Covid-induced swoon of a year ago. In other words, we are back where we were a year ago when there were NO concerns about interest rates (shown as the dashed red line below). Note the 10-year U.S. Treasury rate at 1.5%.

10-year U.S. Treasury rate at 1.5%

Market commentators ascribe a good portion of this rise in longer-term interest rates as reflecting a growing sense that inflation will be ramping up. The first chart below shows that inflation has been held below 3% for the past decade, a downshift from the prior decade. Recent readings are very similar to that 10-year interest rate of 1.5%, meaning that interest rates are offering no “real” return as they are only just covering inflation.

Annual rate of inflationAnnual rate of inflation

The Federal Reserve’s stated target rate of inflation is 2%. However, last year the Fed announced they would allow inflation to rise above their target, acknowledging this would be a feature of an economic rebound in an ultra-low interest rate environment. Perhaps as a result, the inflation rate is expected to rise back above 3% as the next chart shows. Note that the Federal Reserve does not directly control inflation. They do try to influence it through their interest rate and money supply policies.

Inflation expectationsInflation expectations

Taking a step back on both interest rates and inflation reminds us of the long-term average inflation rate of 3.62% and accompanying 10-year interest rate of 5.90%. We have a long way to go to get anywhere close to that interest rate.

Nominal and real 10-year Treasury yields

That 5% interest rate is a key milestone, noted by the vertical orange line below. To the left of that orange line, interest rates and stock prices have a positive correlation. To the right, the correlation breaks down. At 1.5% and, really, anything below 5%, stock prices tend to be in good shape when interest rates are rising. And so we have been, in good shape, with stock prices rising along with interest rates. While there is plenty of chatter lately about inflation, we are just getting up off the ground on inflation and interest rates, with a ton of room above us. The rise is merely reflecting optimism about the economy, in the end; a scenario that typically rewards stock investors.

Correlations between weekly stock returns and interest rate movements

Market Update

Stocks kicked off the week with a solid retreat as last year’s tech/consumer growth favorites continued to face pressure. Rising interest rates are often sited as the reason. But other sectors have also become more favored among investors as the economy recovers, especially finance and cyclical sectors. The selling continued at the outset Tuesday. The Nasdaq was down almost -4% before staging a huge rebound to close off -0.5% while the broader market posted slight gains. Fed Chairman Powell’s comments before a Senate committee appeared to spark the rebound. The leader of the Federal Reserve emphasized that the economy has a long way to go before the group’s economic goals are reached, a signal to investors that easy money will remain in force. Stocks continued their positive reaction Wednesday as Powell presented for a second day. Stocks were left up +1% on the session with smallcap shares doubling that return. The bloom came off the rose Thursday though as stocks hit the skids. Without Fed Chair Powell’s soothing words to support markets, indexes tumbled anywhere from -2% to-4% in a broad selloff. The selling eased Friday leaving the S&P 500 down a more modest -0.5% while the Nasdaq closed up by that amount.

Stocks encountered some notable repricing this week with last year’s performance leading Nasdaq 100 index (QQQ) giving back -5.10%. The relative strength in non-tech areas of the market helped the S&P 500 (SPY) and smallcap Russell 2000 (IWM) indexes to slimmer losses at -2.48% and -3.06%, respectively.

Warm wishes and until next week.