In recent weeks, global interest rates have risen dramatically because of the improving economies of many of the largest developing countries.
Interest rate increases in Europe and America have recently been following each other closely. The 10-Year German bond recently rose above 1 percent from close to zero several months ago. The yield on the benchmark U.S. Treasury note neared 2.5 percent, its highest level in more than eight months. In Japan and the U.K., bond yields rose their highest since November.
Moreover, fixed-income participants now believe that the Federal Reserve will likely raise interest rates this year, possibly as early as September. The Fed’s next policy meeting is happening this week, and investors will focus on its updated assessment of the country’s growth and inflation outlook. These are very important in the timing of an interest-rate increase.
A big reason the Fed is planning to raise interest rates is because the U.S. economy is improving, especially the job market. Unemployment is down to its lowest level since 2008. As Fed Chairwoman Janet Yellen recently commented, “The labor market is improving. Some of the headwinds that have been holding the economy back are beginning to recede.:”
Data from America and Europe indicate that their economies are stronger than was perceived previously. Employment remains strong, and the pace of wage growth has increased.
So an increase in interest rates is to be expected.
Jeff Klingelhofer, co-manager of global fixed-income portfolios at Thornburg Investment Management, said: “Now there is a realignment between yields and economic fundamentals.”
Historically, a primary concern of fixed-income investors is that inflation erodes the value of their bonds. Let me explain: Because bond prices and interest rates move in opposite directions, if prices increase 2 percent, then this decreases the real return of a bond by 2 percent. Therefore, a bond nominally yielding 4 percent provides only a 2 percent real return, after inflation, to its holder. Returns include bond-price gains and interest payments.
Yields still are incredibly low by historical standards. The 10-year Treasury yield was around 3 percent at the start of 2014. It traded above 5 percent before the 2008 financial crisis.
The nominal yield on bonds has raised the attention of the financial community because the bond market has enjoyed a bull market for decades. Central banks flooding the markets with liquidity following the 2008 financial crisis really added sizzle, driving yields to historic lows.
Now, the decline in bond prices has eliminated the bond market’s positive returns. Bond investors will suffer capital losses if bond yields continue to rise.
But the change will help put the stock and bonds back into a more normal balance. Currently, interest rates are so low that they have encouraged an over allocation to stocks and an under allocation to fixed income.
What will an interest increase mean for the average American?
An interest-rate increase will affect borrowers such as people who want to obtain a home mortgage or a car loan. But it will make things better for savers. “The losers will be borrowers and the winners will be savers,” says Ted Peters, CEO of Bluestone Financial Institutions Fund and a former member of the Federal Reserve Bank of Philadelphia.
Ever since the 2008 financial crisis, people who held money market accounts or bank saving accounts have earned almost nothing. With interest rates so low, people who parked short-term money got the short end of the stick. This will change if interest rates rise to historically normal levels.
If the Federal Reserve does raise interest rates in September, the Fed will be doing something that it has not done since Barack Obama was a U.S. senator. A Fed rate hike could make stocks less attractive to investors. It would also raise interest rates on U.S. bonds, which are considered safer investments.
An increase in interest rates is warranted, and desirable, if economic conditions are appropriate.
Originally published in the Sarasota Herald-Tribune
