Why Do Interest Rates Keep Going Up?

ISG

October 9, 2023

Farr Market Commentary with Michael Farr, Hightower’s Chief Market Strategist

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The rise in interest rates from recent lows has been nothing short of remarkable. On the short side, the Federal Reserve has increased its target range for the fed funds rate, which is the rate at which banks lend to each other overnight, from 0.0%-0.25% to 5.25%-5.50% in just 16 months. With the benefit of hindsight, we now know that the Fed was late in waiting until March 2022 to begin that process. Longer- term interest rates started rising much sooner, with the yield on the 10-year Treasury bond bottoming at 0.54% in mid-2020 and steadily rising over the next 3+ year to the current 4.67%. And despite a dramatic moderation in inflation, the spike in longer-term interest rates has only accelerated in recent weeks. Given that both survey-based and market-based estimates of inflation expectations remain well contained, there must be other explanations for the relentless rise in interest rates apart from the fear of resurgent inflation.

Nominal interest rates, which are just the rates you hear quoted in the media, are the sum of two components: the “real” interest rate, which is the rate after adjusting for inflation, and the inflation component. The inflation component represents the average rate of inflation that investors expect over a bond’s term. We can compute this expected rate of inflation by subtracting the real rate, which is the rate paid on Treasury Inflation-Protected bonds (“TIPS”), from the nominal rate. Fortunately, these two rates are readily available from market information services like Bloomberg or FactSet. For example, the current nominal interest rate on the 10-year Treasury bond is 4.67%, and the current rate on the 10-year TIPS is 2.31%. Subtracting one from the other leaves us with an implied average inflation rate over the next 10 years of 2.36%.

There are a couple of things to point out here. First, the expected inflation rate of 2.36%, represented by the gray line in the chart below, is down significantly from a high of nearly 3.0% in April of this year. This means that investors have brought down their expectations for inflation over the next 10 years. The second thing to note is that the real rate, which again is the nominal rate minus the expected inflation rate, has increased dramatically from a low of about -1.18% to the current 2.31%. Because inflation expectations have moderated, we know that the recent spike in interest rates was caused by the 3.5% increase in real, or inflation-adjusted, interest rates.

My apologies for the long, intricate explanation, but it was necessary to make the point that interest rates are no longer being driven higher by rising inflation expectations. One is moving upward (interest rates), and the other is moving downward (inflation). But if not inflation, then what is responsible for the dramatic spike in interest rates? I’d venture to guess that any or all of the following are contributing by affecting either the demand for or supply of Treasuries and other bonds.

Factors Affecting Supply
• Better-than-expected economic growth
• Quantitative tightening by the Fed, which still has a bond portfolio of $8 trillion that it wants to further whittle down
• Huge budget deficits and the need to roll over expiring debt

Factors Affecting Demand
• The massive accumulation of government debt to nearly $33 trillion, which could trigger another debt downgrade; a possible government shutdown would only hasten a possible downgrade
• Efforts by foreign governments to defend their currencies, boost fiscal stimulus and/or diversify their reserves away from the dollar for political or other reasons
• The potential for ancillary factors, like rising energy prices and the UAW strike, to lift inflation expectations for the future

As you can see from the list, it is a combination of surging supply of bonds and insufficient demand for those bonds that is conspiring to drive interest rates higher. Inflation concerns have taken a back seat. I’m not sure how much comfort that should provide us as investors because the bottom line is still that interest rates are rising at a brisk pace, regardless of the causes. But at least we can be somewhat confident that the Fed’s actions have eliminated the worst-case scenario, which is a Volcker-esque campaign of interest-rate hikes leading to a deep recession. Hooray, well done!

Peace, Michael

Disclosures

Investment Solutions at Hightower Advisors is a team of investment professionals registered with Hightower Securities, LLC, member FINRA/SIPC, & Hightower Advisors, LLC a registered investment advisor with the SEC. All securities are offered through Hightower Securities, LLC and advisory services are offered through Hightower Advisors, LLC. This is not an offer to buy or sell securities. No investment process is free of risk and there is no guarantee that the investment process described herein will be profitable. Investors may lose all of their investments. Past performance is not indicative of current or future performance and is not a guarantee. In preparing these materials, we have relied upon and assumed without independent verification, the accuracy and completeness of all information available from public and internal sources; as such, neither the information nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. Hightower shall not in any way be liable for claims and make no expressed or implied representations or warranties as to their accuracy or completeness or for statements or errors contained in or omissions from them. This document was created for informational purposes only; the opinions expressed are solely those of the author, and do not represent those of Hightower Advisors, LLC or any of its affiliates.