Even though the Federal Reserve did not approve another short-term interest rate increase in September, long-term rates nevertheless took a jump for the second straight month. The interest rate on the 10-year government bond went from 4.1% at the start of the month to 4.57% at the end.* When interest rates go up, asset values generally go down, as we all know. But what’s causing this sudden minor headwind for investors, and will it continue?

Before I address that question, let’s talk about how last month’s jump in long-term rates affected your portfolios, specifically. If you’re in a conservative portfolio of bonds and bond-like instruments, you’ll probably see your values down on average by about 1 to 1½% on your latest statement, depending on your individual holdings. That’s about the same size dip you probably saw on your statement last month due to the spike in long-term rates that occurred in August.

If you’re in one of our stock dividend strategies, you may see your portfolio down by about 3% for the month, although year-to-date you should still be about even or down by only about 1% on average – again, depending on your individual holdings. As for the stock market, itself (since rising interest rates negatively affect the value of all assets) it also finished September with all three major indexes in the red for the second month in a row: the Dow fell 3.4%, the S&P 500 slipped 4.8%, and the NASDAQ ended 5.8% lower.**

So, what’s going on? Why are long-term interest rates rising again even though the Fed didn’t raise short-term rates last month and has signaled they’re nearly done (or perhaps already done) hiking altogether? The answer has to do with the fact that the bond market is finally starting to believe another piece of forward guidance from the Fed that it had been skeptical about, which is that short-term rates are likely to remain at their new elevated level for some time to come.

 

A Tale of Two Years

As you know, the Fed began raising short-term rates at a historically aggressive pace last year to fight inflation. This created constant strong headwinds for all investors. As the Fed took its benchmark rate from near zero to 4.25% by the end of last year, the bond market accommodated all those increases with selloffs that also brought long-term interest rates up to nearly 4%.

But this year has been different. As the Fed began slowing its rate-hiking pace in February, the bond market began pushing back. While the Fed’s smaller increases brought short-term rates up to over 5% between February and July,*** long-term rates barely budged, remaining below 4% for most of that time. This was great for investors because it gave their portfolios a chance to recover. From February through July, our own portfolios of bond and bond-like instruments recovered nearly half of last year’s losses and remain up by about 6% on average year-to-date.

Although this pushback by the bond market was nice for investors, it also had a downside because it meant the yield curve was becoming increasingly inverted. As I’ve discussed many times, an inverted yield curve occurs when longer-term bonds pay less interest than short-term bonds. That’s wrong because if you commit to a longer time frame when purchasing a bond you should get more interest, not less. An inverted yield curve also puts the squeeze on banks and other lending institutions, as evidenced by the fact that three regional banks have already failed this year and many others have been flagged as “at risk” by the FDIC. An inverted yield curve is also a classic warning sign of a recession, and, although recession fears had been decreasing for most of this year, they’ve started to intensify again more recently.

It is precisely this yield curve issue that explains what’s been going on with interest rates for the last two months. Before that, the bond market appeared skeptical that the Fed was committed to bringing short-term rates up to almost 6% and keeping them there, especially since inflation has come down to near-normal levels. That skepticism appears to have given way to acceptance.

In other words, when the yield curve is inverted, it can only be fixed in one of two ways: either the Fed must start lowering short-term rates again, or the bond market must admit it was wrong in expecting the Fed to change course, and to start slowly adjusting long-term rates upward again. That second scenario appears to be what we’re seeing now and explains why a slight headwind has returned to the markets.

 

The Bottom Line

So, could this headwind last for a while and get worse? The answer to both questions, I believe, is probably not. The bottom line is that last year we had one of the worst years ever for investors thanks to the Fed, and for most of this year we’ve seen steady improvement. Again, our own portfolios have recovered by nearly half, and I see little evidence to believe we’re going to give back much of that before the end of the year, and virtually no evidence to believe all those gains will be wiped out again.

Be aware, too, that the situation we’re in now is perfectly normal in terms of what typically happens when we’re nearing the end of any rate-hiking cycle by the Fed. The market is simply digesting all the changes of the last year-and-a-half and adjusting to them. This adjustment period may continue for a while and be affected by other things, such as the potential of another government shutdown standoff in November and, again, the ongoing threat of a recession.

Of course, the most important thing to remember, as always, is that regardless of whether the lumpsum value on your accounts goes up or down, it doesn’t really matter because your income return is unaffected. That means if you’re taking your income, a drop in value has no impact on your lifestyle. And if you’re reinvesting your interest and dividends, then a drop in value actually means that you’re dollar-cost-averaging your way to even more income return in the future!

 

* MarketWatch.com

**Federal Monthly Market Wrap: Sept. 2023, Oct. 5, 2023, Nasdaq.com

***Federal Funds Rate History 1990 to 2023, Forbes.com, Oct. 2023

 

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