Do Fed Rate Hikes Mean Bond-Market Disaster?

Are rising Federal Reserve-driven interest rates synonymous with disaster for the bond market?

This is a common question I’ve been fielding in recent weeks—and I’ll cut quickly to the chase. The answer is no—but it might be tough to tell that from recent media coverage associated with rises in interest rates.

To understand why interest rates hikes don’t unequivocally spell disaster for bond holders, it’s helpful to start with a basic question: Why do interest rates rise in the first place? While there can be many individual factors at play, it usually boils down to one overarching reason: Interest rates typically rise because the bond market expects that economic activity will continue to expand and, therefore, that a higher rate of growth will lead to higher inflation expectations.

Put another way, interest rates reflect the bond market’s assumption of what the real economic growth rate is, plus the expected inflation rate. The more volatile of these two components is usually the projected inflation rate.

Going back to September of 1981, the 10-year U.S. Treasury yield was 15.84%. While it’s impossible to know precisely what the market’s expectation for real economic growth was back then, we can assume that it was somewhere around 3%—as that was the average real gross domestic product (GDP) growth rate for the 30 years ending on Dec. 31, 1980. But 3% does not equal 15.84%. So this means that interest rates were likely driven up by very high inflation expectations.

Flash forward to today. Because of a multitude of demographic and productivity factors, we believe that the average real GDP growth rate for the next 20 years will likely linger slightly below 2%. Case in point: The U.S. Federal Reserve (the Fed) now has an inflation target of 2%, as measured by the core personal consumption expenditures (PCE) index. In highly simplistic terms, this would mean that at equilibrium, the U.S. 10-year Treasury rate would be in the 3.5 to 4% range. That’s not even on the same playing field as where things were in the fall of 1981.