How Recently Higher Interest Rates Affect Both The Nation’s And Your Portfolios

Six takes

Figure illustration created with AI assistance based on an author concept

There’s a lot of market chatter these days about interest rates, with nominal rates on some Treasury securities hitting a 20-year high and the President’s insistence that the Board of Governors of the Federal Reserve System lower interest rates, along with his appointment of Kevin Warsh, a recent convert to lower interest rates, as its Chair.

Here is an attempt to help sort through some of that noise, along with details that often don’t make it into newspaper coverage of these events.

Summary

• Real rates have returned to historic levels, which were more prevalent before this century, but the increase largely occurred in the months preceding President Trump’s latest election.

• It is the combination of failing to bring current inflation under control and real rate increases that has led to new, higher nominal (real + inflation) rates.

• Medium- and longer-term bonds were a poor way to diversify one’s portfolio for many years after the Great Recession. Now, just the opposite holds: stock earnings-to-price ratios have fallen nearly to the level of the real rate of return on Treasury securities.

• The market value of household assets still sits in an enormous bubble, with many ramifications yet to be felt for overleveraged purchases, housing ownership, and consumer demand, and, in the absence of a bubble burst, low future returns for holdings of almost real assets.

• Federal Reserve governors may resolve some future debates over looser or tighter monetary policy politically with a two-step process: stimulative interest-rate cuts and contractionary asset sales from the Fed’s large portfolio.

• As for the federal debt, lurking behind everything else is the recent removal of the mask of affordability from the long-term interest cost of accumulating debt at an unsustainable rate.

Further Details

Real interest rates. Real rates on 10-year Treasury Inflation-Protected Securities (TIPS) (next graph) remained near zero from the end of the Great Recession through the end of the COVID-19 era. Then, starting in the second half of 2023, they rose rapidly to a range of 1.5 percent to 2.5 percent (Figure 1). Recently, they settled at a bit over 2.0 percent, though 30-year TIPS are now approaching 3.0 percent.

Figure 1

Expected Inflation. Whether due to tariffs, the war with Iran, or other underlying factors, the recent rise in the nominal rate for traditional (not inflation-indexed) bonds mainly reflects the expectation that today’s higher inflation rates will persist for a while rather than fall to the Federal Reserve’s stated goal of 2.0 percent. Nonetheless, the rise in the real rate, combined with the FED’s inability to bring the inflation rate back toward its 2.0 percent target, leads to comparisons such as the nominal rate now peaking at a level not seen since 2007. Figure 2 shows investors’ expectations for the inflation rate, as determined by the difference between the nominal and real rates in equally timed purchases of traditional and Treasury-indexed bonds with the same 10-year maturity.

Figure 2

Stock returns are hovering near bond returns. Typically, the earnings-to-price ratio on stocks is considered a rough estimate of the real return on those assets. One might have expected the rise in the real return on TIPS (item (1) above) to have led to a reshuffling of portfolios toward TIPS, yet we don’t seem to have witnessed that development. Figure 3 shows earnings levels for the S&P 500 divided by its price level, and, using Robert Shiller’s CAPE measure, the average inflation-adjusted earnings level over the past ten years compared to the current price level. Put simply, the real rate of return on inflation-indexed bonds is nearly as high as the earnings-to-price level of stocks.

Years ago, I tried to convince several portfolio managers that buying longer-term bonds when the real rate was near or below zero was a risky bet, because both inflation and higher real rates increased the risk that the investment’s value would fall. While longer-term bonds indeed proved to be a poor means of diversifying an investment portfolio over much of the period since the Great Recession of 2008-9, that is no longer true, at least for TIPS, as stock ownership has become increasingly risky.

Figure 3

Market value of household assets. Since about 1990, the market value of assets has risen much faster than national income (see chart below). This gigantic bubble could easily burst, but even if it doesn’t, it portends lower rates on almost all assets, not just stocks. I’ve tracked this issue for some time, and what makes these last decades especially unique is that the excess valuation extends across almost all real asset types, from stocks to real estate. That is an aberration. Traditionally, as a share of national income, housing and stock prices have tended to be negatively correlated (e.g., the 70s stock market bust was a housing price boom). I’ve long believed that very low global interest rates have been a major cause of this bubble across asset classes, reinforced by large increases in international financial and investment flows. The evidence is still out on how all this will play out for both your portfolios and monetary and fiscal policy responses.

Figure 4

Upcoming Federal Reserve Debates. In theory, the Fed is supposed to focus only on inflation and employment. But it cannot ignore how financial market reactions to its decisions will affect those two variables. Right now, I doubt the Fed will lower interest rates much while inflation remains so high. Still, I can see possible future compromises between doves and hawks as they address how to manage both interest rates and the large portfolio of assets accumulated largely due to the Great Recession and COVID-19. For instance, at some point in the future, it may experiment with a stimulative lowering of interest rates and a contractionary sale of those other assets (I’m noting, not advocating, this.)

The fiscal mask of affordability on the nation’s debt has been removed. Budget accounting, like most household accounting, is largely on a cash basis. As interest rates fell from the early 1980s through the COVID-19 era, Congress quadrupled the nation’s debt relative to GDP, even as nominal interest rates fell by three-quarters. As a result, the cash-flow cost of interest as a share of GDP didn’t change much. Then, for much of this century, after-inflation interest rates hovered around zero, again pretending that borrowing might be costless.

Now, both of those covers have blown away. As nominal and real interest rates have risen and older debt is rolled over into new securities, both cash flow and real interest costs are increasing faster than the debt itself. That is, these higher rates apply to the debt that must roll over, not just the new debt.