During the month of September interest rates not only continued their march upward, they skyrocketed higher, spooking the stock market and putting stress on financial markets. The move was the most pronounced for long-term interest rates, those with a 20-year or longer term. For example, the 20-year U.S. Treasury bond yield moved from 4.4% on September 1st to 5.15% as of Friday. Mortgage rates also rose, reaching 7.86% as of Friday. Until these past few weeks, the dominant narrative has been that interest rates would soon be coming down, that interest rates were near their peak, and that the Federal Reserve could soon be lowering the Federal Funds Rate. Now there is growing concern that interest rates could go even higher and that they will stay higher for longer than previously expected. So why are interest rates rising? We believe two key factors are inflation and the deficit.
While many factors impact interest rates, one of the key drivers is Inflation and inflation expectations. Investors simply want to have a real return on their money. If investors lend at 4% but inflation is 5% then the inflation adjusted or ‘real’ return is -1%, meaning that investors are losing money. Therefore, banks and bond investors care a great deal about inflation. If you were able to get a mortgage at 3% or below, you should be very happy, but the bank (or investor that bought your mortgage) is really losing money after the 3.7% inflation current inflation rate. This is why it is critical that the Federal Reserve fights inflation and retains its credibility. Investors must ‘believe’ that the Federal Reserve will reach its 2% inflation target. Otherwise, they will charge a premium due to the risk of higher inflation.
As we discussed previously, inflation declined to a low of 3% in June of 2023, but has reversed course for July, August, and September, climbing back to 3.7%. Similarly, interest rates also declined until June but reversed course in July, marching back upward as inflation rose. The reversal has caused doubt about the Federal Reserves conviction and ability to hit 2% inflation. While it seems encouraging that inflation declined from over 9% to 3.7%, there is still a long way to go to 2%. Until inflation clearly starts heading toward 2% interest rates will remain higher.
However, there is a new factor that could be driving the latest rise: the U.S. deficit. On August 1, Fitch Ratings downgraded U.S. debt. This was a wake-up call for investors that U.S. spending was getting out of control. As a result, commercial banks, and international investors reduced their holdings of U.S. Treasuries and U.S. Agency securities. The U.S. Government has had to pay higher interest rates in order to attract buyers. Remember that much of the Federal deficit over the past decade was funded through purchases by the Federal Reserve, artificially pushing down interest rates. Now the Federal Reserve is no longer buying U.S. Treasuries and the deficit must be funded by investors. Given high inflation and high government spending, investors seem unwilling to buy treasuries unless the interest rate is compelling.
Normally, budget deficits get larger during recessions and then narrow during economic expansions. One major concern is that the U.S. budget deficit is growing in the midst of a strong economy. Further, the interest cost of the U.S. debt is rising rapidly, growing faster than any other budget item. Social Security payments have jumped due to cost-of-living adjustments, adding cost to this major outlay. The bottom line is that the U.S. Government is spending more than it brings in and investors are beginning to get worried. In fact, investors may be more focused on the deficit than inflation itself. Even after weak economic indicators at the end of September that would signal lower inflation, interest rates continued to rise.
Clearly, interest rates are headed in the wrong direction. We are hoping that there will be good news on the inflation and deficit front. If not, we could be facing interest rates for a long time to come.