Economic Risks: Substantially higher interest rates starting in 2022

Interest rates will rise substantially in the next few years. Many current financial planners and portfolio managers are ill prepared for this likely scenario.

Background on Interest Rates:

  • Interest rates have been abnormally low since the 2008 financial crisis. The average 2021 10-year interest rate was 1.45%.  The average 10-year Treasury bond interest rate between 2011 and 2021 was 2.11%.  The average 10-year interest rate during the 2008 to 2010 financial crisis was 3.38%.  By contrast, the average 10-year treasury rate stood at 4.71% between 2000 and 2007, 6.67% between 1990 and 1999, 10.59% between 1980 and 1989, 7.50% between 1970 and 1979 and 4.97% between 1963 and 1969. See this chart by Macro Trends for annual data.  
  • The Federal Reserve Board has been tremendously accommodative over the last three years due to COVID with the current discount rate at 0.25%. However, the Fed taper program is ending and most market participants are expecting three increases in the discount rate next year.
  • The Federal Reserve Board has control over the interest rate at the discount window but does not control long-term interest rates, which are affected by inflation and inflationary expectations.  The primary determinant of inflationary expectations and long-term interest rates is wage inflation.  Price inflation cannot occur for a sustained period unless the cost of creating goods and services increases. Wages are the major source of the cost of goods and services.
  • Many analysts believe that inflation is peaking.  I am less sanguine. Many people concerned about COVID have left the labor force.  This trend could accelerate because of the CDC decision to reduce the quarantine period for people exposed to COVID.  Older people who left the workforce early due to COVID may not return.  The decline in both legal and illegal immigration has reduced labor supply.  My forecast is for sustained wage and price inflation regardless of what happens to the supply chain.  Note, that these factors impacting labor supply are not directly controlled by monetary policy.

This increase in inflation will inevitably lead to higher interest rates.

Consequences of higher interest rates:

A prudent investor considering bonds compares current interest rates to historic ones and assumes some sort of movement towards the mean.  This analysis suggests there is currently very little upside and substantial downside in holding traditional fixed-income assets or fixed-income funds. Treasury bond interest rates will inevitably rise creating real financial hardships for investors, retired people living on 401(k) funds and borrowers.

  • The increase in long-term interest rates will lead to a decline in the value of the bonds and losses for investors who sell their bonds after interest rates rise.   The increase in interest rates will also decrease the value of bond funds held in 401(k) plans.  During the 2008-2010 market downturn the decline in the value of stocks was somewhat offset by an increase in the value of bonds dampening the market downturn. The next financial collapse could involve decline of stocks and bonds in tandem.
  • The increase in bond yields will not simply result in a loss of real return to investors.   The actual market value of the bond and the amount received by the investor will fall when the asset is sold.  (I heard an analyst on CNBC state that the loss for investors stemming from an increase in rates would only be in real terms because the investment would not keep up with inflation.   This is categorically false.  An increase in rates even if only to the pre-2008 levels would lead to substantial nominal losses.) 
  • Bond holders who hold a bond to maturity will receive face value for their investment.  However, many bonds held in ETFs or mutual funds like VBMFX, have no maturity date.  Investors regularly sell shares in bond ETFs to fund consumption in retirement and the value of these shares falls when interest rates rise.
  • The cost of credit and loans moves with interest rates.  The interest rate on federal student loans has been explicitly linked to the 10-year Treasury rate over the last decade.   A rise in student debt rates induced by the increase in Treasury rates will reduce household spending and the ability to save for retirement.

A potential solution for investors:

  • A person concerned about inflation should consider purchasing up to $10,000 a year in I-Bonds from the U.S. Treasury.  The return on I-bonds is the sum of a nominal interest rate and the inflation rate.  People who cash in an I-bond less than five years from their purchase date will forfeit 3 months interest.   The current nominal interest rate on an I-bond is low but the current return from inflation is substantial. Also, people who purchased I bonds when interest rates were high have both a high nominal interest rate and returns from inflation.
  • Investors should purchase I-bonds up to the allowable limit every year.  Investors purchasing an I-Bond will not experience a capital loss when rates rise. Go here for a discussion of I-Bonds.