Equity markets continue to respond to higher interest rates on the long end of the bond yield curve, but thankfully the Fed is looking at the big picture – and they see a curve that is shifting upward. This is positive, so why is everyone freaking out?
Higher interest rates are a good thing
First of all, yes, interest rates are up, because a bit of inflation is finally coming into the system.
This is exactly what the Fed has been trying to do: rekindle some inflation. You may recall that former Chair Ben Bernanke and the Federal Open Market Committee worked hard to fight off deflationary tailwinds that were holding back the economy. They put several QE programs in place and used other tools to gain a bit of leverage. It appears that new fiscal policy and the tax cuts in 2017 were just what the Fed needed.
Inflation isn’t the boogey man
When the Fed raises the funds rate, they are simply removing the generous accommodation policy that has been in place since the financial crisis in 2009. For better or worse, the Fed’s mission is to stoke some inflation (they’re looking for 2-2.5%) and manage it accordingly. Fortunately, the economy is on rather sturdy ground, making it much easier to raise interest rates slowly until they reach their target inflation of around 3% per year.
The bond yield curve is healthy
As I mentioned earlier the yield curve is sloping upward at a modestly steep rate. As rates rise across the curve, the bond market is not forcing the Fed’s hand. Rather, it is doing its job. When the bond market says, “Yes, rates have to rise because the economy is solid and slight inflation is coming in” – that’s healthy.
What’s next?
The Fed is on a path to raise rates three times in 2018. They left the door open for a fourth if inflation starts to rise, but we are not seeing signs of higher inflation in gold, silver or the dollar, so this is unlikely. Long-term bond yields are at 3% (vs 2.5% a couple of months ago), so they are still not competitive against equities. If/when the economy turns south, bonds will become more attractive and yields might be much higher than current interest rates.
So yes, it is good that we have higher interest rates. There is no need to panic, because the current market conditions are just what the Fed wanted.
