Why investors shouldn't worry about rising rates

The Federal Reserve is expected to keep raising short-term interest rates this year - and the bond market has taken n...

Posted: Jul 24, 2018 7:04 PM
Updated: Jul 24, 2018 7:04 PM

The Federal Reserve is expected to keep raising short-term interest rates this year - and the bond market has taken notice.

The yield on the benchmark 10-year US Treasury isn't far from 3%. Rates hit 3% in April for the first time since 2014 before eventually edging lower. Now yields are climbing again, but that hasn't sent shudders through investors in stocks. The Dow was up more than 200 points Tuesday, and the tech-heavy Nasdaq hit an all-time high and closed in on 8,000.

Why aren't investors freaking out about higher rates?

The spike in yields reflects a healthy economy. Dow components Verizon and United Technologies as well as Google owner Alphabet and drug giant Eli Lilly all reported strong earnings in the past few days.

Bond yields should move higher if the economy is in good shape, especially if the Fed is hiking rates to keep inflation in check. And as the 10-year yield moves up, something called the yield curve is starting to widen again. That's a good thing, too.

Related: JPMorgan Chase CEO Jamie Dimon talks exclusively to CNNMoney about the economy

The yield curve is the difference - or spread - between long-term and short-term rates, typically the 10-year and 2-year Treasuries. The spread had been narrowing, a phenomenon known as a flattening yield curve.

Economists worry when that starts to happen because it could eventually lead to a flip-flopping of rates, short-term yields higher than long-term yields. That's called a yield curve inversion and it often is a precursor to an economic downturn.

An inverted yield curve seems to be less of a concern now, though, as longer-term rates have inched back toward 3%.

Some experts think the 10-year yield will climb even further this year and into 2019, but not so dramatically that it starts to lower demand for consumer and business loans.

Matt Toms, chief investment officer of fixed income for Voya Investment Management, said he thinks the Fed will only raise rates once or twice in 2019 and that the 10-year yield will top out in a range of 3.15% to 3.35%.

As long as the Fed doesn't hike rates too aggressively, the yield curve should keep widening.

"The flattening should diminish. The Fed is no longer going to be on autopilot because it will be hesitant to invert the curve," Toms said.

Alec Young, managing director of global markets research for FTSE Russell, agrees. He said that the Fed realizes that gradual rate hikes should not be a problem for investors or consumers.

"If the 10-year moves from about 2% to 3.35%, that's fairly innocuous," Young said. "The bond market doesn't seem to be thinking that rates should be that much higher than that."

Related: Trump takes issue with Fed rate hikes

Ronald Temple, head of US Equity at Lazard Asset Management, also thinks that the recent spike in rates is a good sign and not a cause for concern. He notes that wage growth has been picking up and the housing market is still fairly healthy.

"The US economy has been in better shape than people realized for the past few years," Temple said.

Temple added that the only reason bond rates had dipped in the past few months after topping 3% in April was because of the possibility of more trade spats between the United States and China, Europe, Canada, Mexico and other nations.

Concerns about trade haven't gone away. But Temple thinks investors are less worried about them - despite more protectionist tweets from President Donald Trump - because earnings have been solid and "companies are not complaining too vocally."

That's why Temple thinks investors are now more focused on Friday's report on economic growth. Economists are forecasting that the US economy grew at an annualized rate about 4.2% in the second quarter. That would be the fastest pace in nearly four years.

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