Getting Comfortable with Being Uncomfortable: Market Update October 2023

Oct 26, 2023

Higher interest rates have been a shock to many of us. The bond market, the economy, US homebuyers – all of these have gone through a major adjustment over the past year as rates have increased dramatically. While we certainly don’t know exactly where interest rates should be and where they are going to go from here, what we can say is the level of interest rates we’ve gotten used to over the last 14+ years leading up to 2022 was NOT normal and this new level of rates reflects a tremendous opportunity for investors to actually get decent yields on bonds, which is something we haven’t seen in a long time.

Following the Global Financial Crisis that started in 2008, the US Federal Reserve Bank (who essentially controls short-term rates), pushed yields to the floor (what we have commonly referred to as “ZIRP” = Zero Interest Rate Policy). Simply put, these lower-than-normal interest rates stimulated the economy when the economy was going through its rough patches. But here’s the problem: while the low rates helped in times of crisis, keeping them low for too long, paired with expansive fiscal stimulus (government spending), was likely to create negative side effects. Namely, inflation.

Short-term rates that were in the 0-2% range were stimulative, but not appropriate for the long-term as it may encourage behavior that is not sustainable (i.e., excessive risk-taking). So how about the current short-term rates (around 5.0-5.5%)? This is likely in or close to “restrictive” territory and is a function of the Fed playing catch-up due to the still elevated inflation rate.

The hike in interest rates since the beginning of 2022 was broadly expected to trigger a recession; but so far, the US economy has proven resilient in the face of higher borrowing costs, which has only pushed rates higher on the notion that rates will need to stay higher for longer (at least compared to expectations). Hence the sizable increase over the last year in the 10-year treasury bond yield (from the high 3% range to now close to 5%!).

Certainly, we will have another market shock or crisis down the road (it’s not an “if” but a “when”), and it would be reasonable to assume that rates will be cut again as the Fed uses the same playbook as before. But barring a major market meltdown, the path for now appears to be elevated rates. However, rates will likely oscillate within a wide range from here as the economic data continues to be unclear (sometimes conflicting) and there isn’t a clear consensus about what will happen (even within members of the Federal Reserve Bank!).

So, here’s the key point: higher rates can be viewed as a good thing (unless you are loaded with too much debt). Assuming we get inflation under control, then getting a positive “real” rate of return (meaning the return after deducting the cost of inflation) on your bond investments is great news (something that was difficult to do during the low-rate regime). Furthermore, these higher rates are generally a sign of a healthy economy that can stand on its own two feet again rather than needing the stimulative effects from monetary policy (but it’s kind of like weening off coffee for a caffeine addict).

From an investment standpoint, we’re excited to see good-quality, lower-risk bonds that are paying meaningful interest rates for our clients’ money again. It certainly helps to hit financial goals without having to take as much risk (generally speaking, better returns at lower levels of volatility). For stocks, quality businesses will continue to navigate the dynamic environment, and may likely thrive in a higher-rate environment. The smart business managers locked in low rates when they were available, unlike weaker businesses that will be subject to risk when their low-rate debt matures, and they are forced to refinance at higher rates (a death-knell for some of the barely profit companies out there). Again, we don’t know if rates continue to go up, sideways, or down, but we are happy with the current opportunities.

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