Implications of Higher Longer-Term Rates
By Kevin Kelly, Partner & Portfolio Manager
Sticky inflation, a relatively strong labor market, solid economic growth, and especially ongoing government budget deficits are all contributing to higher interest rates on long-dated Treasuries (10-30 years). While tariffs and the magnitude of budget deficits remain uncertain, any effort to trim the deficit seems highly unlikely to produce a budget surplus. For context, the last budget surplus occurred in 2001. Additionally, the extremely accommodative monetary policies that many central banks instituted after the global financial crisis have ceased and are unlikely to be repeated. Therefore, other than a major global economic slowdown, we expect long-dated Treasury rates to likely remain higher for longer. When we say higher, we are comparing the outlook for the next five years to the rates in the decade or so after the Global Financial crisis and prior to Covid (i.e., the period of 2009-2020). We believe that the potential impacts of higher longer-term interest rates will vary across consumers, small and medium sized businesses, and large companies.
Regarding the consumer, large ticket purchases have and likely will remain somewhat constrained until consumers reset their expectations of interest rates. However, a strong economy and the wealth effect of a very strong stock market may continue to support spending despite the significant rise in rates. The most notable impact has been witnessed in sales of existing homes with sales in 2024 hitting a 29- year low. Anecdotally, many homeowners are delaying home sales because most refinanced to enjoy a low mortgage rate. They won’t give up that low rate to buy something else with current mortgage rates approaching 7%. According to Realtor.com data as of 2Q’24, more than 55% of mortgages are below 4% and nearly 75% are below 5%. While life events continue to happen regardless of the interest rate environment, the velocity of home sales, primarily existing home sales, will likely remain subdued for a few years. It is worth nothing that the existing home sales market is dramatically larger than the new home sales market. Additionally, many new homes sales are occurring where land is more plentiful as many well-established cities and suburbs are already built out. Over time consumers will adapt, and as Home Depot’s management team highlighted on their recent earnings call, large remodeling projects and existing home sales will likely improve once consumers accept the new rate environment. On a positive note, retirees and savers are generating meaningfully more income on their savings.
For small and medium-sized businesses (SMBs), there are varying aspects to consider in relation to the higher interest rate environment. First, small businesses care more about the health of the US economy than rates per se. Low rates in a challenging economy are a much worse scenario than higher rates in a strong economy. Additionally, while a tight labor market presents challenges, the labor market is a bit more balanced than two years ago. We note, however, that futures changes in the rate of immigration into the U.S. are likely to have an impact on the labor market and wages. Furthermore, it is worth noting that the latest National Federation of Independent Business Small Business Optimism Index is at the highest level since 2018. However, many SMBs that need financing may struggle to find attractive terms in the higher rate environment and in the wake of the regional banking crisis which caused many banks to tighten lending standards. While uncertainty persists, SMBs could also disproportionately benefit from any trade policy that makes the U.S. more competitive.
While their stock prices could be negatively impacted, large companies are more immune to the current interest rate environment. First, many of the larger companies have only a moderate level of debt so a few percent rise in interest rates does not materially affect their cash flows and net income. Second, the vast majority of the debt of large companies is at a fixed rate for an extended period of time. This means large companies do not instantly benefit or get harmed when there is a large shift in interest rates. For context, the average maturity of Corporate U.S. Investment Grade Bonds exceeds 10 years (per the Bloomberg US Corporate Bond Index), so the impact of interest rate changes takes a very long time to fully impact company’s earnings and cash flows. Notably, the average Corporate U.S. Investment Grade Bond has an average coupon of 4.15% versus a yield of just more than 5%. Hence if all these bonds needed to be refinanced tomorrow the effective interest rate on the debt would rise less than 1%. Therefore, the current higher interest rate environment should only have a moderate, and lagged impact on corporate profits. Higher rates also create an ancillary positive for fixed income investors: they make leverage less attractive and this makes CFOs more likely to maintain a conservative level of debt. Large companies also benefit from their access to public bond markets which offer a much lower cost of financing than a bank or private lender.
We currently see limited downside pressure to long-term interest rates short of a major macroeconomic recession or massive geopolitical uncertainty. By contrast, we think the 3-7 year Treasury curve could decline significantly in a mild or moderate recession. For this reason, we are focusing most of our fixed income exposure in the 3-7 year horizon. Bond yields are composed of an interest rate component and a risk component (credit spread). In the current environment, we find intermediate (3-7 years) Treasury rates attractive in a sub 3% inflation world and remain disciplined in regards to credit risk. Since corporate bond risk premiums are currently low, we are positioned as conservatively as we have been in many years. We would strongly discourage investors from chasing an extra point or two of yield unless they are diligently researching individual securities like we do at ACM. Buying numerous fixed rate corporate preferreds or very long-dated corporate bonds yielding less than 6% is simply not attractive when the 30-year Treasury yields more than 4.8%. Just like the Federal Reserve has a dual mandate of maximum employment and price stability, ACM’s fixed income team has a dual mandate of Capital Preservation and Income Generation.
The foregoing content reflects the opinions of Advisors Capital Management, LLC and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. Past performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful.