Where are Interest Rates Heading?

The chances are high that many have seen the recent headlines that interest rates could stay “higher for longer.” But what exactly does “higher for longer” mean and is this a foregone conclusion or just a possibility? Also, where did this “higher for longer” term come from? We will address each.

But first, let’s see where rates are today (black line) relative to the last six months (red line), a year ago (green line), and 18 months ago (orange line). The chart below represents the yield curve. Horizontally we are looking at maturity while vertically we are looking at yields.

A year and a half ago, we had a normal yield curve that was upward sloping to the right. Today, because of tighter interest rate policy imposed by the Federal Reserve, short term rates are higher than most long-term rates, giving us an inverted yield curve. Often, but not always, an inverted yield curve precedes a recession.

But, Jim, if an inverted yield curve precedes recessions and growth is slowing, why doesn’t the Federal Reserve just act proactively by cutting rates before a recession happens?

This is the question many are asking and, in most circumstances, if growth was slowing enough, this would most likely be the path – to cut rates sooner than later. But the Federal Reserve is in a quandary right now, because inflation is still too high, and some are concerned that it will reaccelerate. To reiterate Fed Chair Powell’s question last week “is the heat that we see in GDP, is it really a threat to our ability to get back to 2 percent inflation?” This is the predicament. We’ve had better than expected economic growth and a more resilient labor market recently, but too much growth and this can contribute to inflationary pressures.

This is where the “higher for longer” term comes in. The chart below shows the Federal Reserve participant’s dot plots. Participants are members of the Federal Reserve Board and Federal Reserve Bank presidents. The dots on the left represent where each participant viewed projected rates on June 14 of this year. The dots on the right represent where each participant viewed projected rates on September 20. You can see the 2024 annotation with the yellow circled dots (from last week) is slightly higher than the 2024 dots circled in green (last June).

Source: Federal Reserve Summary of Economic Projections, 6/13/23 (left) and 9/20/23 (right)

Higher for longer essentially means that rates in the short term, the rates that the Federal Reserve controls, may stay higher for a longer period of time. This also implies that longer term rates may temporary stay higher due to longer range expectations shifting slightly higher. This all implies that the yield curve inversion could stay with us longer and that rates will fall more slowly than what many had hoped for. The chart below is what Fed Funds Futures are currently implying based on the recent dot plots. This implies that we may get one more hike and that any rate cuts may not start until the second quarter of next year, but we could see additional cuts, especially in the second half of next year.

Source: Bloomberg, as of 9/27/23

It’s important to know that these things can move up and down and change significantly even over short time frames. Current assumptions are scarcely set in stone as the data is always changing, higher or lower than what is expected. Like a plane that is off course to the flight path 90% of the time, the current dot plots and Fed Funds Futures will not likely stay static. We believe it is more likely that these will shift lower over the coming months.

We will likely see inflation pressures come in lower. We will also likely see slower growth than what many anticipate, especially heading into next year. Whatever the data is, this will influence the dot plots and the Fed Funds Futures and markets, in general.

Here’s what each scenario means and what we foresee is the probability is for each outcome:

Lower inflation and stable growth (50%)

• Interest rates fall gradually as inflation comes down.
• Unemployment stays low, but gradually climbs higher.
• Savers will make less money in cash when short term rates start coming down.
• Stocks perform well.
• Bonds perform well.
• Housing becomes more affordable as rates come down.

Little change in inflation and higher growth (25%)

• Interest rates stay higher for longer.
• Unemployment stays lower for longer.
• Savers continue to benefit from high short-term rates.
• Some stocks perform well while other stocks perform poorly.
• Bonds perform poorly.
• Housing stays unaffordable for many people.

Lower inflation and a recession (20%)

• Interest rates come down very fast in order to stimulate the economy.
• Unemployment increases significantly.
• Savers, out of concern, may keep more money in cash, even if it pays little or no interest.
• Most stocks perform poorly but rebound as policymakers seek to stimulate the economy.
• Bonds perform very well as interest rates come down sharply.
• Housing prices fall significantly but become much more affordable for would-be home buyers.

Higher inflation and a recession – stagflation (5%)

• Interest rates stay higher for longer and may need to be increased to fight ongoing inflation.
• Unemployment increases significantly.
• Savers are the only one benefiting, making even better income on higher short-term rates.
• Most stocks perform poorly, and this drags on for a while until inflation comes down significantly.
• Bonds perform poorly as rates not only stay high but could increase across all maturities.
• Housing becomes less affordable due to higher rates, but prices also fall significantly. This feels like a lose/lose scenario for sellers and borrowers.

Summary

We believe the recent market sell-off in both bonds and stocks is mostly related to concerns about higher short-term rates imposed by the Federal Reserve for a longer period of time. We are also aware that August and September often have more seasonal weakness and market volatility, especially when compared to November, December, and January, which have seasonally represented stronger performance historically.

We believe the current trajectory of rates with their implications towards both bonds and stocks will likely be revised to reflect slowing growth and inflation that will likely recede faster than most anticipate, especially as we get closer to the end of the year.

We continue to advocate for portfolio diversification and investing based on long-term goals, not on day-to-day or week-to-week market gyrations.

Securities offered through LPL Financial, Member FINRA/SIPC.  Investment advice offered through WCG Wealth Advisors, LLC a Registered Investment Advisor.  The Wealth Consulting Group and WCG Wealth Advisors, LLC are separate entities from LPL Financial.