The US economy has undergone drastic change over the past four decades and one trend stands out from the rest, a sharp and steady drop in interest rates. the 10-year Treasury yield fell from over 15% in 1981 to a historic low of 0.52% in August 2020 (see graph below). During the same period, the federal funds rate fell from 20% to near zero, and the 30-year fixed mortgage rate fell from over 18% to less than 3%.
As we sit here today, the S&P 500 is trading near all-time highs and the median US home price is the highest it has ever been. This can be hard to believe when we look back to March 23, 2020, when the S&P 500 had just fallen almost 34% in 30 days. But with the economic uncertainty that has resulted from the COVID-19 pandemic, the U.S. government and the Federal Reserve have given record stimulus packages, including major bond purchases. This pushed up bond prices, causing interest rates to drop significantly.
Since its low in the second half of 2020, the 10-year yield has since climbed to over 1.7%. This recent rate hike is likely due to expectations of higher-than-expected economic growth as some investors fear further stimulus will boost inflation. While not too much of a concern in the short term, a sustained rise in rates makes borrowing, lending and raising capital more difficult. This can create challenges for businesses in terms of growing, investing and meeting their financial projections, and for individuals facing increased borrowing costs and the ability to purchase more expensive goods.
What does a sustained rise in interest rates mean for your investment portfolio? Although we have seen a sharp and steady decline in rates since 1981, there have been many periods of short-term rate hikes during this period. The table below shows the performance of the different asset classes over different time periods where the 10 year yield increased by more than 1%. The average length of the periods examined was approximately 19 months, with an average rate increase of approximately 2%.
Bonds are usually hit hardest during periods of rising interest rates, as their fixed payments become less attractive compared to new issues, resulting in lower prices. Investors should focus on the overall duration (sensitivity to interest rates) of their bond portfolio, as longer-term bonds are most affected. On the other hand, bonds with shorter maturities are less impacted and help reduce the portfolio’s sensitivity to interest rates. The average returns of the Bloomberg Barclays Govt / Credit 1-3 Yr Index, the Bloomberg Barclays Agg Index (approximately 6 years duration) and the Bloomberg Barclays Us Gov / Credit Long Index (approximately 13 years duration) years) were 3.9%, 2.2% and -2.1%, respectively.