Financial markets are all agog over falling short-term interest rates following the Federal Reserve’s interest-rate cut this month.
But the real action could be at the long end of the yield curve, which often is more important than the short end for inflation, the economy and risk assets such as stocks. And long-term rates may not join their short-term brethren in moving down, already moving up in recent days. This could be bad news for inflation, the economy and risk assets.
Higher long-term rates are inflationary because they raise borrowing costs for loans, such as mortgages. Higher long-term rates hurt the economy by discouraging borrowing, which means less economic activity. Slower economic growth depresses corporate earnings, which hurts stocks.
The 10-year Treasury yield stood at 4.11% Monday, up 11 basis points over the past week.
So what could make long-term rates rise?
First, there’s inflation. The Federal Reserve’s favored inflation indicator, the personal consumption expenditures price index, rose 2.6% in the 12 months through July. That’s far above the Fed’s 2.0% target.
Second, the government is a huge long-term borrower, which forces rates higher on its long-term debt. The government budget deficit stood at a whopping $1.8 trillion last year, or 6.4% of GDP. And it’s likely to stay massive.
Third, corporations, especially technology companies, are borrowing prodigious sums of money to finance artificial intelligence activity. That money is flowing for everything from expensive personnel to data centers.
Last year, corporate AI investment totaled $252 billion, with an estimated 40% to 50% coming from loans. Experts see total investment soaring to $300 billion-$400 billion this year.
Implications for stocks
As a stock investor, you might wonder how you should deal with rising long-term rates. If you’re looking to buy stocks in this environment, you might consider high quality stocks with growing dividends.
High quality means stocks with strong earnings and management. They often outperform the market as a whole when it drops, which it could well do as a result of ascending long-term rates. Companies that raise their dividends over the years are generally able to do so because of their solid finances.
Possible targets include Broadcom (NASDAQ: AVGO), Microsoft (NASDAQ: MSFT), JPMorgan Chase (NYSE: JPM), and Eli Lilly (NYSE: LLY). All of these companies are high quality and have raised their dividend for at least 10 straight years. Keep in mind, of course, that there’s no guarantee they will perform well.
In any case, it will serve investors well to pay attention to long-term interest rates. And if they rise, be prepared for trouble in the economy and financial markets.
The author owns shares of Microsoft, JPMorgan and Eli Lilly.
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