Why higher rates aren’t necessarily bad news.

Although stocks were mixed at the index level last week, strength was seen beneath the surface. The Russell 2000 was the best-performing part of the market, and the equal-weight S&P 500 also had another strong week. The Treasury market rallied again, providing ballast to equities as the yield on the 10-year declined to 5 percent.

BEYOND THE HEADLINES:

Why higher rates aren’t necessarily bad news.

The Fed meets this week to deliberate on short-term interest rates. Market participant opinions as to whether the Federal Open Market Committee (FOMC) will raise rates again after its September increase have shifted dramatically in the past month. Investors who once expected another rate hike now largely expect the central bank to leave rates unchanged this week and reconsider the need for additional increases when it meets again in December.

As always, post-meeting comments from Fed Chair Kevin Warsh will be critical for investors. Although Warsh has historically avoided giving guidance, his answers will be parsed for insights into whether he supports a December rate hike.

While the Fed controls short-term rates, it does not control the yield on the 10-year Treasury bond. This yield has been in the news lately after it surged higher and then quickly moved lower as investors sold stocks and moved to safer assets. It’s important to note that current yields are not out of line with historical levels.

What Is the Fed Looking At?
The key driver of the Fed’s interest rate increase in September was accelerating inflation. Although inflation data continued to move higher at the consumer and producer levels in the past month, a softer-than-expected September employment report could buy the central bank time to raise rates again. This doesn’t mean, however, that the Fed won’t continue to focus on inflation.

Warsh has made it clear that the Fed’s goal is to rein in inflation. It has been more than five years since inflation was below the central bank’s 2 percent target. While much of inflation’s move higher can be tied to tariffs and higher oil prices, those factors are beginning to affect other components of inflation, such as core goods. This suggests that even if we get an agreement to end the war between the U.S. and Iran, the Fed may still need to raise rates, barring an unforeseen economic slowdown.

10-Year Yields Alone Shouldn’t Pressure Stocks
While Fed decisions rightfully receive attention, the 10-year Treasury yield is also critical. Recently, the 10-year Treasury yield reached levels last seen in 2002. Although that seems like a significant development on the surface, it’s important to note that 10-year Treasury yields from 2008 to 2022 were abnormally low.

That period was a particularly strong one for equity investors, but low rates aren’t necessarily needed to generate strong returns. Yields between 4 percent and 6 percent are normal when viewing them through a longer-term lens. One only needs to go back to the 1990s to see yields at that level, along with strong economic growth, strong earnings growth, and strong returns for stock markets.

Higher Yields Could Be the New Normal
At the same time, higher Treasury yields present options for investors, particularly those seeking income. Relatively risk-free investments at that level not only provide attractive yields, but bonds at current levels could also return to their diversification role for equity investors. That possibility was on display on Thursday, when 10-year yields dropped 19 basis points (bps) because of a sell-off in technology stocks.