Why are long-term interest rates rising?

Unlike short-term rates, which are mostly driven by the U.S. Federal Reserve’s (Fed's) monetary policy, the yields on longer-term securities are in large part a reflection of market forces—namely, supply and demand. Yields rise as prices fall, of course, and an increase in yields can reflect a number of factors on both sides of that supply-and-demand dynamic. Here are four reasons why interest rates have been rising in 2021.

End of an era? Yields have reversed course, rising sharply off recent lows
10-year U.S. Treasury yields since 2011 (%)
TL-37611-10-years-US-treasury-rates-chart-800px

 

Source: United States Department of the Treasury, as of March 9, 2021. Past performance is not indicative of future results.  


 

1 U.S. Treasury debt levels have never been higher

One reason yields on U.S. Treasury debt have moved higher is because there’s just so much of it. In the absence of new buyers, increased supply often leads investors to demand higher levels of compensation to absorb the excess issuance—and that translates to higher yields. Too much debt can also raise questions about borrowers’ ability to repay it.

U.S. Treasury debt has skyrocketed since 2008
U.S. federal debt as a percentage of GDP, 1966–2021
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Source: Federal Reserve Bank of St. Louis, as of March 9, 2021. 


 

2 The economy may be picking up steam

Another factor driving yields is the more optimistic outlook for the economy. A strong economy has historically been tied to higher yields on long-term debt, in part because investors tend to gravitate to riskier assets—such as stocks and high-yield bonds—that have tended to outperform when the economy is heating up. Less demand for such defensive asset classes means they need to offer higher yields to attract buyers.

After a wild ride in 2020, the economy may be poised for growth
U.S. gross domestic product, percent change, 2017–2020
TL-37611-US-GDP-change-chart-800px

 

Source: Bureau of Economic Analysis, as of March 12, 2021.

 

3 Inflationary forces could soon be on the rise

Another factor pushing rates higher today is the outlook for inflation. Bond investors often make buying decisions based on a security’s “real” interest rate, which reflects the income earned after accounting for the erosive effects of inflation. The higher the rate of inflation, the higher the level of income investors demand. While the rate of inflation today remains fairly subdued—still below the Fed’s stated 2% target—market watchers believe there are reasons to expect it may soon turn higher—maybe significantly so.

Inflation expectations are rising, but overall levels remain subdued
Consumer Price Index, excluding food and energy, 2011–2021 (%)
TL-37611-Inflation-remains-relatively-muted-chart-800px

 

Source: Federal Reserve Bank of St. Louis, as of March 9, 2021. 

 

4 A weakening dollar is creating additional headwinds

About one-third of U.S. Treasury debt is held by foreign investors, including both foreign governments and institutions. Naturally, the U.S. government is both borrowing and repaying foreign creditors with U.S. dollars. When the dollar weakens, that means it’s worth less and less of any individual unit of a foreign currency—a trend that makes U.S. debt less appealing to foreign investors. One way those investors can respond is by demanding higher yields to compensate for the currency risk associated with dollar-denominated debt.

The U.S. dollar has weakened significantly since the pandemic began
U.S. Dollar Index performance since January 2020
TL-37611-The-dollar-has-been-steadily-weakening-since-the-pandemic-began-muted-chart-800px

 

Source: Yahoo Finance, as of March 9, 2021.


Actively manage interest-rate sensitivity

Not all segments of the fixed-income market are equally sensitive to changes in interest rates; high-yield bonds and securitized debt, for example, can often be more correlated with the macroeconomic backdrop than with the direction of interest rates. Investors may want to consider taking steps to ensure their portfolios offer exposure to a range of market segments in order to diversify away from a single source of risk, like duration.



Broadly diversify, including with international positions

Just like the dynamic with individual segments of the bond market, not all regions are experiencing the same macroeconomic conditions as the United States. For example, emerging markets, Asian, and Latin American economies all offer ways to diversify a bond portfolio away from U.S. market risks, while also providing an opportunity to pursue additional incremental income.



Consider tactical opportunities

One last consideration is to introduce tactical positions into a portfolio. Floating-rate notes, as the name suggests, offer variable interest payments that reset higher when interest rates rise. Certain segments of the stock market may also be worth a look. The banking sector, for example, has historically outperformed when there are relatively wide spreads between short- and long-term rates.