How investors can prepare if higher interest rates stick around

• A resilient economy and a tight labor market mean inflation may remain a threat, potentially keeping interest rates elevated.
• Morgan Stanley’s Global Investment Committee (GIC) sees longer-term government bond rates normalizing between 4.5% and 5.5%, amid 2.5% to 3% GDP growth and inflation.
• Some investors are cautious and defensive, positioning their investment portfolios with a focus on medium-term bonds and quality stocks.

Investors hoping for a reprieve after months of short-term interest rate hikes from the Federal Reserve may have longer to wait before rates settle down.

In fact, the yield on the 10-year Treasury note has climbed an entire percentage point over the past few months and is now at a 16-year high around 4.7%, rattling equity investors and driving a retreat in benchmark stock indices.

Some investors today might view the recent rise in longer-term rates as temporary and hope for a quick return to an era of lower rates. While the GIC does see the US economy possibly slowing and interest rates declining over the next nine to 12 months, there are mounting risks that rates could instead stay elevated alongside robust growth and persistent inflationary pressures.

Considering the above—and keeping in mind that individual investors’ circumstances will vary based on their goals and risk tolerance—the GIC believes some investors may:

• Stay defensively and cautiously positioned and balance equity exposure in their portfolios between offensive and defensive stocks, with a particular focus on quality.
• Move toward medium-term bonds, where historically high yields may be found.

Two factors that could keep interest rates higher in the near term:

• A resilient economy and a tight labor market mean inflation remains a threat. Even with all the interest rate hikes over the past 18 months, households and businesses have been spending money and keeping the economy more robust than previously expected. The labor market also remains tight and capital spending has been consistent. These factors suggest inflation is still a threat, and the Fed will have to crush consumption or the labor market—or both—to bring inflation back to target.
• The US government has issued a surge of debt that could see fewer buyers. For instance, the traditional banking system is funding itself through reserves rather than Treasuries, and foreign buyers may be pulling away as well, with Japanese investors constrained by yen weakness, and China continuing to reduce its share of US government bond purchases since 2018. Political wrangling in Washington doesn’t help investor confidence in the Treasuries market, either.

The GIC believes longer-term government bond yields are likely to normalize somewhere between 4.5% and 5.5%.

The logic is that the post-COVID US economy looks more like the post-World War II period than post-2008, with growth and inflation around 2.5% to 3%. This could drive some investors to demand government bond yields in this higher range.

A resilient economy, tight labor market, and a surge of Treasury issuance amid potentially weakening demand for US government debt could mean interest rates remain elevated for some time.

The GIC believes some investors may balance equity exposure in portfolios and move toward medium-term bonds.

The source of this article, Why Higher Interest Rates May Not Go Away, was originally published on October 11, 2023.