US interest rates have increased this year as the Federal Reserve continues to hike short-term rates and investors demand higher returns on longer-term lending. This has pushed the yield on the 10-year US Treasury bond, a key interest rate benchmark, slightly above the 3% level, matching its high from 2013. The question many analysts are now asking is: Which way will interest rates trend from here?
On the one hand, the 10-year Treasury bond has been in a trading range between 1.5% and 3.0% since the middle of 2011. Should this trading range hold – perhaps due to increased trade war fears, an economic slowdown, or subdued inflation statistics – the next move for interest rates could be downward as the current period of prolonged interest rates persists. In this scenario, investors may benefit from holding longer-term bonds as bond prices tend to increase when interest rates fall, with longer-term bonds realizing the greatest amount of appreciation.
On the other hand, the recent increase in interest rates may be a sign that the bond market is preparing to break out of its seven-year trading range with interest rates finally exceeding the highs from 2013. In this case, investors may favor short-term bonds and other less interest-rate-sensitive investments. Typically, when interest rates increase, short-term bonds offer more price stability than longer term bonds.
Rising interest rates may have other implications beyond the investment realm as well. Higher interest rates will push up borrowing costs on everything from credit cards to auto loans to home mortgages. Some would argue that could cause consumer spending to slow as households must dedicate more of their income to interest payments and become hesitant to borrow to fund continued spending due to the higher debt costs. With consumer spending comprising nearly two-thirds of US economic output, a decline in consumer spending could lead to an economic slowdown or even a recession.
On the other hand, some would argue that the US economy is robust enough to continue to grow despite higher interest rates. After all, even at a level exceeding 3%, the interest rate on the 10-year US Treasury bond would still be near historically low levels. Therefore, consumers may continue to borrow to spend and businesses may continue to borrow to invest, at least until interest rates reach a level closer to the highs for past cycles, which is well above the current level.
Regardless of which viewpoint an investor may take, they likely agree that interest rates should be monitored closely. Interest rates can be thought of as the price of money and therefore have an impact on many areas of the economy and financial system. As the price of money goes up, the supply may increase as households favor saving to earn the new higher interest rate over spending. In addition, the demand for money may fall as borrowers choose to pay down debt to avoid paying the higher costs of taking on debt.