Short-term interest rates may keep falling, and long-term rates may keep rising

When the Federal Reserve began lowering short-term interest rates in September, many investors believed long-term rates would fall too.

But that hasn’t been the case. The 10-year Treasury yield has climbed to 4.18% from 3.64% on Sept. 17, the day before the Fed began cutting. (To be sure, the yield has slid 27 basis points since Nov. 13).

The direction of long-term rates is important because it has major implications for the movement of equities, including bank and real estate stocks, bonds, and other assets.  

A resilient economy has helped push long-term rates higher, with GDP growing an annualized 2.8% in the third quarter. Strong economic growth lifts interest rates by boosting demand for borrowing.

The divergent rate pattern may continue. Interest-rate futures indicate a 66% chance that the Fed will decrease short-term rates again at its next meeting Dec. 18.

If that happens, long-term rates may climb again. That’s because short-term rate cuts generally boost economic growth and inflation. The Atlanta Fed forecasts GDP growth of 2.6% for the fourth quarter.

Long-term rates also may rise amid fear of rising inflation that could result from tariff increases, tax cuts and expanding budget deficits. Inflation lifts long-term rates because lenders demand compensation for interest payments that are devalued by climbing prices.

Normalization of the yield curve also could pull long-term rates upward. Short-term rates are higher than long-term rates now, meaning an inverted yield curve. 

But that usually happens only during periods of economic weakness. Given the economy’s current strength, there’s a good chance the yield curve will go back to normal, with long-term rates rising above short-term rates.

Implications for stocks

High long-term rates often hurt the stock market by putting a crimp on economic activity. But there are sectors that can withstand higher long-term rates. Banks in particular benefit from a combination of lower short-term rates and higher long-term rates. 

That’s because they pay short-term rates on their customers’ deposits, but can make loans or buy bonds with long-term maturities—i.e. higher interest rates. The KBW Nasdaq Bank Index (NASDAQ: BKX) of bank stocks already has jumped 43% year to date.

On the negative side, real estate and utility stocks tend to decline when long-term rates ascend. That’s because rising rates make the companies’ dividend payments less attractive compared to bonds. And both real estate and utility companies do a lot of borrowing.

If you’re a bond investor, rising long-term rates give you an opportunity to buy bonds offering attractive interest payments. If you purchase a Treasury bond and hold it until maturity, you’re almost certain to get your principal back. And if you want to take a little more risk for a little more yield, you can acquire investment-grade corporate bonds.

Rising long-term rates can signal rising commodity prices, including gold (CME: GCG5). That’s because rising long-term rates are generally a sign of inflation or a reaction to it. And commodities can act as a hedge against inflation.

Thus higher long-term rates may be coming, but investors can take advantage of the move.