Higher for Longer?

August 9, 2023

Interest rates have been stickier than a kid’s face after eating cotton candy at the fair.  Not only have they stayed higher than most economists and market participants thought, but they actually increased over the past few weeks.  Part of this can be attributed to the surprising downgrade of U.S. debt by the Fitch rating agency, but that doesn’t appear to be the whole story.  The 10-year treasury yield, as of this writing, is at 4.08%, which is higher than any time going back to the great recession of 2008.  Will interest rates stay higher for longer?  Are intermediate-term bonds the good deal we thought they were going into the summer?

A few short months ago investors were on recession watch with the belief that higher rates would finally catch up to the U.S. economy, unemployment would take off, and the economy would sink.  This narrative did not happen as the economy continued to strengthen adding more jobs each month and corporations kept making money as consumers dipped into savings and used more credit for purchases.  Instead of a recession, which could cause interest rates to fall (potentially sharply) the economy is chugging along and interest rates remain stubbornly high.

Earlier this year we believed intermediate-term bonds looked very attractive, especially if interest rates began to moderate and fall.  This could create a great environment for bonds as investors collected the dividends and also reaped capital appreciation on their bonds – as interest rates go down, the value of bonds moves up.  This dynamic cut both ways and as interest rates have moved higher, the total return on bonds and bond funds has been much lower than we anticipated.

Now we find ourselves contemplating the direction of interest rates over the coming months.  Will inflation continue to moderate?  Will the cumulative effect of rising interest rates over the past year start to finally wear down the economy and put us into a recession?  Will this cause rates to start falling, creating a strong return environment for bonds?

Nobody knows the answers, but the recent rise in rates has increased our conviction that we are nearing the tipping point.  After many years of languishing in a low interest rate environment, it most definitely feels good to book CD or money market rate near 5% and having some exposure to these instruments makes sense.  However, we think the potential returns on intermediate-term bonds still look attractive over the next 12-18 months.

The Bond&Devick Team