When Will Interest Rates Stop Rising and What is the Impact on the Market?
Hello everyone. I hope all is well.
Here is the latest edition of 3 Questions for Bill Richardson.
Question 1: When are interest rates going to stop rising?
The timing of this question is interesting. When you look at interest rates, there are two major ways to view them. Most investors focus on short-term rates. Bank of Canada rate, prime rate, treasury bill rates and mortgage rates. For this discussion, we’ll focus on Canadian rates.
The other way to look at rates is looking at longer-term bond yields. Many institutional investors and bond funds focus more on longer-term maturities, like 5-to-30-year bonds.
The Bank of Canada influences short-term rates. These rates can be more volatile and tend to react quickly to short-term economic factors, including liquidity conditions in the financial market.
Longer-term rates are Influenced by long-term expectations about the economy and inflation, factors like the country’s fiscal situation, and international capital flows. These rates tend to be more stable than short-term rates but can shift with changing macroeconomic expectations.
Normally, long-term interest rates are higher than short-term rates because of the added risks associated with lending money over longer periods. This typical condition creates an upward-sloping yield curve.
However, there are times when short-term rates might exceed long-term rates, leading to an “inverted yield curve.” This inversion is often seen as a precursor to economic recessions.
Question 2: So why do you say the timing of this question is interesting?
What most investors see and track is short-term interest rates. It is always a major event when there is an announcement that the Bank of Canada rate increases or decreases, but you seldom hear that bond yields have risen or fallen. If there is some discussion about longer-term rates, you might hear that “the bond market was strong today” or “bonds fell sharply in today’s trading”. When the bond market is strong, it means that longer-term bond yields fall and vice versa.
Short-term rates started rising in April 2022 with a 0.5% increase to one percent and have risen in a rapid-fire manner to 5% in September 2023. This has been great for short-term investors or investors in floating rate investments as they have seen treasury bills and GIC rates exceed 5%. On the other hand, borrowers who have short-term or floating rate loans are feeling extreme pain as mortgage rates, for example, have increased mortgage payments beyond the ability to keep up and still put food on the table for many people, and the bulk of locked-in rates will begin to expire over the next two years.
Longer-term yields have taken much longer to rise. When short-term yields rise sharply, you get what they call an “inverted yield curve” due to the slower-rising long-term yields.
Now, we are getting to the interesting part. 10-year bond yields began rising in early 2021, and by the time the Bank of Canada rate rose to 1%, 10-year yields had risen from 0.5% to 2.5% and kept going until they reached 3.5% in June 2022.
This was an especially bad time for bondholders. During this period, the benchmark XBB ETF had fallen in price by almost 16.5%. To be fair, investors would have received their interest payments, but that would have only trimmed the loss to 13.3%. It was not great for what was thought to be a safe investment. This is a big reason why we have focused our fixed income attention on the Private Debt category, as we were worried about what would happen to bonds if interest rates rose.
By June 1, 2022, short-term rates had only risen to 1.5%. The bond market had predicted that short-term rates were going to rise, and they did. From June 2022 through August of 2023, Canadian 10-year bonds traded in a range of 2.5% to 3.5%, while short-term rates rose to 5%.
Question 3: How do longer-term yields affect the stock market?
When 10-year bond yields rose between January 2022 through October 2022, the S&P 500 dropped approximately 24%. When they stalled in the 2.5% to 3.5% range, the S&P 500 rose over 29%.
Since August, 10-year yields have moved higher again and hit a new high of 4.28%, and the S&P 500 fell over 7%.
Why is the timing of the question interesting?
10-year bond yields are a great barometer for the stock market, even more than tracking short-term rates. Timing is interesting because we are currently experiencing a rapid rise in longer-term rates in both Canada and the US.
Bonus question: Where do we go from here?
10-year yields in the US hit a peak of 4.88% in early October. Five percent should provide strong psychological resistance. Equity markets have already begun a recovery as yields have dropped back a bit.
I’m not predicting, but if 10-year yields hold the 5% level and maybe trade in the 4% – 5% range, equity markets may get back on a more positive path until 5% is breached.
Enjoy your day,