Written by Alex Seleznev, MBA, CFP®, CFA | Jan 22, 2025
For anyone who follows the economy or stock market, you’ve probably noticed that interest rates come up in almost every commentary on the topic. At its simplest, lower interest rates are better for the economy and stock market and higher rates are usually the opposite.
But, just like in any relationship or "correlation" in finance, things aren’t always as clear cut as they seem. In this newsletter, I want to break down, in simple terms, how interest rates might affect your financial plan or investment strategy.
To keep you updated, the yield on the 10-year Treasury, or the "market" yield, has jumped significantly over the past month or so. This is one of the largest increases ever during a time when the Fed is cutting interest rates. And this could have a big impact on both the economy and the markets. Here's why it matters to you.
1. Borrowing costs are rising
Long-term interest rates are connected to loans like mortgages.
Even though the Fed has lowered short-term rates by 1% since September 2024, the average rate on a 30-year mortgage has gone up from 6.73% to 7.04%.
This makes homes harder to afford and slows down new construction in the housing market which is a key part of the economy.
2. Stocks could struggle with higher rates
Higher long-term rates reduce the value of future earnings for companies which makes stocks less attractive.
The 10-year Treasury yield is often used as the “risk-free rate” in financial models, so when it rises, stocks can fall.
While another major selloff like 2022 is unlikely, rates staying above 5% could still make it harder for stocks to perform well.
3. The Fed might lose trust
The Federal Reserve (Fed) needs people to believe in its decisions.
If markets think the Fed is lowering rates too soon, while inflation is still high, it could lose credibility.
Without that trust, it becomes harder for the Fed to influence the economy through its policies.
4. Government debt keeps rates under pressure
The U.S. government is running a yearly budget deficit of over $1.8 trillion and it’s expected to keep growing.
This puts long-term pressure on interest rates, making it unlikely they’ll return to the lower levels we saw between 2009 and 2019.
5. High rates could cause a recession
If rates stay too high for too long, it could slow the economy so much that we enter a recession.
Even though the Fed is cutting short-term rates to help, higher market rates are still holding back key areas like real estate which is crucial for economic growth.
What Does This Mean for You?
The gap between falling short-term rates and rising long-term rates adds more uncertainty to the economy.
Bonds have adjusted to this, but the stock market hasn’t fully reacted yet.
After two strong years for stocks, it’s a good time to check your investments.
Do you have too much money in large tech or growth stocks? Rising rates could make these richly priced stocks fall more than other categories.
Higher interest rates have already taken a toll on interest rate sensitive small-cap stocks which fell more than 10% in December 2024.
If you’re nearing retirement or already retired, make sure your investments are set up to handle these challenges.
As Benjamin Franklin famously said, “By failing to prepare, you are preparing to fail.”