Why High Interest Rates and Energy Prices Are Stressing the Economy

Interest rates are rising. Oil prices are climbing. On their own, either might be difficult to swallow.

But mixing them creates a nasty concoction — one that is distasteful for consumers, off-putting for most investors and dangerous for the economy.

The interest rates I’m referring to are set by traders in the vast fixed-income market. There, Treasury yields have risen to their highest levels in decades, increasing costs for consumers and businesses, unsettling the stock market and complicating the Federal Reserve’s efforts to subdue inflation without causing a recession.

At the same time, oil prices, which had fallen from peaks reached in 2022 early in Russia’s war with Ukraine, have resumed a surge upward. They are hovering above $95 a barrel, and that expensive oil has pushed the average price of gasoline in the United States above $3.80 a gallon — uncomfortably close to the $4-a-gallon mark that has set off consumer alarms and political tremors over the last few decades.

Add the strong dollar, which depresses foreign earnings for U.S. companies, “and you’ve got a trifecta that is very difficult for the economy to handle,” Liz Ann Sonders, the chief investment strategist at Charles Schwab, said in an interview.

Undoubtedly, there has been a great deal of good news about the U.S. economy lately, and it’s possible that there will be a “soft landing” and inflation will fall to the Fed’s 2 percent target without a major economic slowdown.

But unless and until that happens, I’d keep hedging my bets. Ms. Sonders says the economy has been experiencing sector-by-sector “rolling recessions,” which have already hit the housing and manufacturing sectors and are likely to spread further. A full-blown recession remains a possibility, and with government shutdowns and endless strife over fiscal policy becoming normal events, it’s smart to prepare for trouble.

The Fed Pause

The Federal Reserve directly controls only short-term rates, and the discrepancy between those rates and the longer-term rates set by the bond market has loomed in importance over the last couple of years.

Since November 2022, the bond market has been signaling that a recession is likely, with a pattern known as “a yield curve inversion” in which longer-term rates are lower than the rates set or most influenced by the Fed. When the economy falters, inflation typically recedes, but so far, no recession has come and inflation is still too high for the Fed’s taste.

At its last meeting in September, the Fed held interest rates study but also said it would keep them above 5 percent through 2024. Longer-term rates have risen, acknowledging that reality.

With the new appeal of those higher bond yields, and the threat to corporate profits posed by higher borrowing costs, the yield surge has been disrupting the stock and bond markets.

For long-term investors who can afford to ride out this period, these issues may not matter much for your portfolio down the road. Just hang in, and make sure you have enough money put aside to pay the bills. Eventually, the markets will settle, but it may be a bumpy stretch.

To understand what’s going on, recall, first, that to tame raging inflation, the Fed raised the federal funds rate, its main policy rate, from near zero at the beginning of last year to a range of 5.25 to 5.5 percent in July. It then held rates steady at its most recent meeting in September. The Fed funds rate is about as short-term as you can get: It’s what banks are allowed to charge one another for overnight loans. The Fed has also raised or influenced a number of other short-term rates.

The Good Part

This is a boon if you are fortunate enough to be a saver. Thanks largely to the Fed, money market funds will pay you more than 5 percent for just parking your money with them for a while, and short-term Treasury bills and many high-yield savings accounts are offering generous yields as well.

If you have been enjoying those higher yields, the positive spin on the revelations from the September Fed meeting is that you will be getting a handsome yield for quite some time, without having to take the risks of investing in stocks or longer-term bonds.

Similarly, if you are a world traveler with plenty of dollars in your pocket, you will be able to live large for quite a while when you travel abroad.

And Yet

The strong dollar has depressed S&P 500 earnings and contributed to a flagging stock market and a difficult economic environment in countries that must deal with increased costs for imports and worse terms for exports. Oil prices rose after Saudi Arabia announced supply cuts, enriching energy producers and burdening most other companies and most consumers. In much of the world, oil is paid for in dollars, and the combination of rising prices and a strong dollar is a double whammy that brings pain and not much else.

Perhaps the greatest economic problem in the trifecta of energy prices, the dollar and higher interest rates — is the effect of rising rates.

A broad range of consumer loans — from credit cards to car loans to mortgages — have become much more expensive, and while the economy has continued to grow, these costs are beginning to crimp spending. Interest rates and gasoline prices were probably behind a decline of consumer confidence in August, reported in a long-running survey by the Conference Board, a business think tank.

Rising rates have caused acute distress for traders who have made aggressive bets on long-term bonds. While money-market funds and Treasury bills have been generating wonderful yields, long-term bonds have produced major losses when traders have sold them. This is because of an essential feature of bond math: Interest rates and prices move in opposite directions, and when interest rates rise, prices fall. Furthermore, bonds of longer duration fall more in price when yields increase.

A Horrendous Return

Witness the remarkably terrible performance of the iShares 20 + Treasury Bond exchange-traded fund, which faithfully tracks an index focused on “U.S. Treasury bonds with remaining maturities greater than twenty years.” Since a peak in late July 2020 through Sept. 28, the fund dropped roughly 45 percent in value.

The fund has done just what it was designed to do: track the performance of long-term Treasuries. They remain solid investments, although Moody’s Investor Service says government shutdowns are “credit negative” events for U.S. sovereign debt.

But the surge in bond yields — which reflects concern that the Fed’s inflation fight will take longer than anticipated and may require even further rate increases — has made trading Treasuries hazardous. It may be that rates are already near a cyclical peak, which would make it wise to purchase longer-term Treasuries right now. A safer bet is to keep the duration of your bonds down. You won’t gain as much if yields drop, but if they rise, you won’t endure the severe paper losses of long-term bond holders.

The yield surge has also wrong-footed stock investors who had hoped that inflation would be under control by now and that the Fed would be nearly done with its tightening. The disturbance in the bond market led to losses over the last couple of months for stocks, which had been rising this year.

It’s an unsettled time, and the economy and markets may be subjected to greater turmoil than we have seen so far. There is much that the Fed simply can’t control.