Should You Worry About Rising Rates?

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Katie Nixon, CFA, CPWA®, CIMA®

Chief Investment Officer, Northern Trust Wealth Management

February 19, 2021

Your Questions Answered

Recent higher interest rates reflecting upward revisions to growth and inflation have some investors concerned about a risk asset selloff if key levels are breached. But assessing the full scope of interplay between near-term inflationary pressures, the longer-term disinflationary secular backdrop and, critically, the Fed’s stance is necessary to weighing the risk case. Below we provide five answers to varying aspects of one core question: Should you worry about rising rates?

1

Not Yet. Treasury yields are rising for the right reason.

In 2020, the rates market played the role of pessimist against the risk asset optimist. Yields were suppressed not only by central bank intervention but also by concerns about the timing and pace of global economic recovery. Sequential global COVID-19 infection waves, along with delays in vaccine deployment, served to amplify concerns of more permanent economic scarring.

Conditions have changed considerably over the last several weeks, with accelerated vaccine approval and deployment joining flattened case curves and contributing to greater optimism about 2021 growth. The odds have also risen for a very large fiscal stimulus package (consensus is for well over $1 trillion) out of Washington, lending more confidence to an expected surge in economic activity during the second half of the year.

Greater optimism around the macroeconomic backdrop is being reflected in sharply higher Treasury yields at the 5-year maturity and beyond as well as steeper yield curves. This is to be expected in a period of economic recovery and has been the norm based on past post-recession periods. Notably, this optimism is being reflected in sovereign bond markets around the world, with Bunds and Gilt yields continuing to rise in lockstep with yields in the U.S.

If rates are rising based on more normalized growth expectations, we believe risk asset markets remain well supported. Ultimately, we believe that any further advance in rates will be constrained as fiscally-induced “pops” to demand fade in 2022 and beyond.

2

Not quite. Near-term inflation concerns are real, but transitory.

We are clearly seeing signs of near-term inflationary pressures, driven by some supply constraints, higher import prices, higher transportation costs and significantly higher commodity prices. It is possible that these pressures could intensify as economies reopen more durably later this year and already constrained supply meets strong pent-up demand. Further, “base effects” will also provide a strong tailwind to reported inflation, as this year’s rates will be measured against an extremely weak 2020 backdrop. For perspective, the year-over-year CPI in May of 2020 came in at just 0.1%. So it is reasonable — in fact, expected — that we will see much higher headline numbers this year.

This possibility is not lost on investors: Market-based inflation expectations have risen considerably. For example, the 5-year breakeven inflation rate has risen to 2.29%, a full 34 basis points higher than it was on December 31.

We remain confident that our “Stuckflation” theme — that inflation will face structural headwinds over the intermediate and longer term — remains valid, while acknowledging that it will be tested over the near term. Investors will be well served to distinguish between a cyclical uptick in inflation and the disinflationary secular backdrop.

3

Not so far. The increase has been quick but orderly.

There has been widespread concern that any breach beyond key levels — a 1% or 1.25% 10-year Treasury yield — would drive a significant sell-off in risk assets, particularly if it occurred quickly. We have breached both levels, and quickly, yet risk asset markets remain relatively well-behaved.

While interest rates may have risen under the tailwind of upward revisions to both growth and inflation, both of these variables tend to also be positive for equities — to a point. It is only when rates rise in a disorderly fashion that risk asset markets react negatively. While equities initially faced selling pressure, we appear to be ending the week embracing the reflation trade, despite the continued climb in Treasury yields.

4

Not so fast. Despite the recent move, interest rates remain extremely low by historical standards, and financial conditions remain easy by any measure.

Investors can be forgiven for falling into the common behavioral bias trap of anchoring bias, the tendency to focus on the value of a certain information anchor, which sets the baseline for all subsequent decisions. In this case, the anchor is the low point of 0.52% for the 10-year Treasury yield, which was struck back in August of 2020. Against that anchor, today’s 1.33% yield seems an enormous move, particularly given that 40 basis points of the increase has occurred just in the past seven weeks. Importantly, we need to look back at history and recognize that even at current rates, Treasury yields are far below longer-term averages — and well below even the average over the past 10 years.

In terms of financial conditions, we consider the equity market as an input, but we also look to credit markets to assess whether conditions are loose or tight. Both investment grade and high yield credit spreads continue to narrow even as Treasury yields rise, leaving financial conditions easy by any measure.

5

Not a chance. The Fed will not tighten policy any time soon.

Key to our outlook is the premise that the Fed will not react to the increase in inflation or inflation expectations and will remain ultra-accommodative for the foreseeable future. Recent comments from members of the Federal Reserve Board indicate a consensus that the U.S. economy remains “far from normal,” and Fed Chair Powell has taken each and every opportunity to reassure investors that the Fed would consider near-term inflationary pressure to be transitory. The adoption of a new inflation framework, moving from a point-in-time target of 2% to an average of 2%, leaves the Fed tremendous flexibility, and we believe that it will use that flexibility to wait even longer before considering whether to modify policy. The market is taking the Fed at its word that short rates will be anchored at zero for a considerable time — as reflected by the 2-year Treasury yield, which has remained stable at roughly 0.11%, despite the rise in rates of longer-dated Treasuries.

Disclosures

This document is a general communication being provided for informational and educational purposes only and is not meant to be taken as investment advice or a recommendation for any specific investment product or strategy. The information contained herein does not take your financial situation, investment objective or risk tolerance into consideration. Readers, including professionals, should under no circumstances rely upon this information as a substitute for their own research or for obtaining specific legal, accounting or tax advice from their own counsel. Any examples are hypothetical and for illustration purposes only. All investments involve risk and can lose value, the market value and income from investments may fluctuate in amounts greater than the market. All information discussed herein is current only as of the date of publication and is subject to change at any time without notice. Forecasts may not be realized due to a multitude of factors, including but not limited to, changes in economic conditions, corporate profitability, geopolitical conditions or inflation. This material has been obtained from sources believed to be reliable, but its accuracy, completeness and interpretation cannot be guaranteed. Northern Trust and its affiliates may have positions in, and may effect transactions in, the markets, contracts and related investments described herein, which positions and transactions may be in addition to, or different from, those taken in connection with the investments described herein.

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