As of late I have seen numerous articles and comments made that just because the Federal Reserve raises interest rates it will only affect the short end of the yield curve, but not the long end. This premise is used to support the bullish thesis that the Fed can raise the overnight lending rate, but leave longer-term interest rates low thereby supporting economic growth and elevated stock prices. However, is this the case?
To answer that question, we must look at the history of the two interest rates in question. I have used a 3-month treasury rate which replicates the Fed Funds rate. In order to more clearly see the trend and turning points of the two rates, I have smoothed both using a 12-month average.
The dotted black lines denotes when the 3-month treasury began to increase. Note that in every instance the 10-year rate began to increase as well.
Of course, this is perfectly logical. Banks borrow money from the Federal Reserve at the lower rate and then lend out at a higher rate which is typically benchmarked to the 10-year treasury. When the banks borrowing costs increase the rate at which they lend out also increases as higher costs are passed through to borrowers.
Rising rates are historically associated with stronger levels of economic growth as borrowers can justify higher interest rate costs as the spread between the loan and capital project are profitable. However, as rates continue to rise, net profitability is reduced which ultimately acts as a “brake” on economic activity.
As shown in the table below, increases in interest rates eventually have a deleterious outcome to either the economy, financial markets or both.
The table above shows the start/end of the interest rate increase cycles for both rates. In all cases, as the short-term interest rate rose the longer end of the yield curve also increased. The impact of higher borrowing costs, as stated above, has always led to negative outcomes. As I addressed in
