Why rising long-term rates could ripple across the economy
The central story in financial markets over the last couple of months has been a surge in longer-term interest rates, fueled by a growing consensus that elevated borrowing costs — at least compared to the 2010s — are here to stay.
Why it matters: The latest move higher in long-term rates is already hammering stock prices. Over time, it is likely to create new cracks in the economy as well.
By the numbers: The benchmark 10-year Treasury yield reached 4.52% this morning, a new 16-year high. It was 3.35% as recently as early May.
- These long-term rates are not directly driven by the Fed's interest rate policy but rather by markets' expectations for how growth and inflation will evolve, how the Fed will react in the future and the supply of longer-term bonds from the U.S. government.
- This particular run-up is mainly driven by a rise in real interest rates, not by higher investor expectations of inflation. It implies that investors increasingly think the Fed will have to keep its interest rate target high indefinitely to hold inflation down.
Between the lines: It takes time for the impact of higher long-term rates to filter through to the economy.
- With the 30-year fixed mortgage rate well north of 7%, home sales and building activity could see another leg down. Already, a slowdown in residential investment has subtracted from GDP growth for nine straight quarters, with the steepest drags occurring in the second half of last year as an earlier spike in rates had its effects.
- Some corporate debt rates have risen as well (though not nearly as much as Treasury yields have), which could make companies more reluctant to spend and invest in the coming months.
Of note: A new index created by Fed staff earlier this year aims to capture how much financial conditions are poised to slow or stimulate the economy. It emphasizes the levels of mortgage rates and corporate borrowing rates — not, as some other such indexes do, the spread between those rates and Treasuries.
- In other words, the rise in rates seen in recent months would be expected to slow GDP.
Powell's long-rates shrug
The selloff in the stock market last week, alongside the renewed surge in yields, appears to be driven in part by a sense the Fed is unconcerned about the economic ramifications of high long-term rates.
State of play: Fed chair Jerome Powell was asked about the rise in bond yields at his news conference last week, and his answer seemed more like a shrug than an expression of alarm, which fueled the sense in markets that rates are likely to stay high.
- Powell said that "they're moving up. It's not because of inflation."
- "[I]t will probably have something to do with stronger growth, I would say more supply of Treasuries," he said. "You know, the common explanations that you hear in the markets kind of make sense."
- That came after Fed officials released projections showing the consensus of policymakers is that they will keep their rate target above 5% throughout next year and that five officials believe that in the long run, rates will hover significantly higher than they did in the past.
Meanwhile, the central bank's "quantitative tightening" program continues apace, shrinking its balance sheet by up to $95 billion a month. That essentially lowers demand for longer-term bonds, a force helping drive their rates higher.
What they're saying: Market developments in recent days "underline our concern that the Fed erred in not putting enough weight on the big rise in longer-term yields," said Krishna Guha and Marco Casiraghi of Evercore ISI in a note.
- They add that its communications are "being read in markets as inviting yields to surge still higher at a time when there is pressure from massive supply of debt … along with more structural shifts in the global economy."