Interest Rates: The Bigger Picture

Last week, I stepped away from the markets and stressed the importance of having a written financial plan. This week, I'm circling back to something that has been particularly relevant in the markets and economy: interest rates.

The Federal Reserve raised its benchmark interest rate by 0.25% this week, bringing its target range to 3.75% to 4.00%. It was the first rate increase since 2023, reflecting the Fed's continued focus on bringing inflation back toward its 2% target.

But there is another interest rate worth watching.

The 10-year US Treasury yield has recently moved above 5%, a level we have not seen since 2007.

At first glance, that may seem surprising. If the Fed controls interest rates, why is the 10-year yield so high?

The answer is that the Fed controls short-term rates, while longer-term rates are largely determined by the bond market. The 10-year yield reflects expectations for inflation, economic growth and future interest rates, along with the compensation investors require to lend money over a longer period.

That distinction matters because the 10-year Treasury influences much more than the bond market.

Longer-term Treasury yields are an important reference point for borrowing costs throughout the economy. Fixed mortgage rates, corporate borrowing costs and other forms of longer-term lending are influenced by where longer-term bond yields are trading. When the 10-year yield rises, the impact can eventually extend beyond investment portfolios and into household finances and business investment.

There are several reasons longer-term yields have moved higher. Inflation remains above the Fed's target, economic activity remains relatively resilient, government borrowing remains substantial, and there is uncertainty about where interest rates ultimately settle.

For investors, I think the bigger takeaway is that we may need to get comfortable with a world where interest rates remain meaningfully higher than they were for much of the past decade.

That is not necessarily a bad thing.

Higher yields create more attractive income opportunities for bond investors and can improve the long-term return potential of fixed income. At the same time, higher rates place greater importance on valuation when investing in equities and other risk assets.

This is why we continue to focus less on predicting exactly where rates will go and more on understanding what the current environment means for portfolios.

The 10-year Treasury may not make for an exciting headline, but it is telling us something important: the era of exceptionally low interest rates may be behind us.

That is an important change for investors to understand.

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