Tuesday, October 13, 2026
As we all know, the Federal Reserve controls the overnight lending rates that banks can charge each other for their excess reserves or what is called the Federal Funds rate. This rate has a direct impact on money market yields and the short-term bonds we invest in. This past quarter was interesting in that the bond market is in the driver’s seat and is influencing longer term rates (e.g. mortgage rates) and it seems to be also suggesting that the Federal Funds rate should be higher than it is given that the two-year treasury yield is at 4.8%. Currently the Federal Funds rate is at 3.75%. Some analysts believe the two year is telling the Fed that they are behind the curve – by one full percent! The bond market is also forcing the 10-year treasury yield to approximately 5.3% – a yield we haven’t seen since 2002. The 10- year treasury is the benchmark yield 30-year mortgages are based on. Why are we seeing higher yields and how will these higher yields impact the economy and stock market?
The US government has a spending problem. Or perhaps they have a revenue problem. The current US debt just surpassed $40.3 trillion dollars and the US fiscal deficit is adding $2 trillion per year. To put that in perspective, the US gross domestic product (GDP) – or the revenue our country produces in one year – is $32.5 trillion. We just recently surpassed the GDP and I am thinking that is one of the many reasons fixed income investors are selling their bonds. Keep in mind, when I say bond investors, think investors like you and me, but there are other huge holders of US treasuries and they include countries like China, Japan and…hedge funds. I have been reading reports that China has been selling treasuries. What in the world would China consider safer than a US treasury? Apparently, it is gold and it may be one of the reasons gold prices surged last year (gold is down year-to-date). When demand for US treasuries drops, prices also go down and yields go up to attract new buyers. You will see this reflected in any portfolio holding intermediate bonds this past quarter. That is where hedge funds have stepped to the plate and picked up the slack that China left in the US treasury market, but only to a point. Other factors driving up bond yields: Rising inflation expectations by bond investors watching the war in Iran as well as the artificial intelligence (AI) build out.
Higher yields are rippling through the economy. Mortgages and consumer loans such as credit cards and car loans are quickly showing rate increases. As we already know, mortgages are directly impacted by the 10-year treasury. Since the 10-year is higher, 30-year mortgage rates are now over 7%. That is having a direct impact on lower end housing. My neighbor down the street had only one person stop by during their open house this past weekend. A few months ago, the Madison housing market was one of the hottest in the country. With rates as high as they are, housing will slow in the months ahead. Ironically, consumer spending doesn’t seem to be slowing down.
Jeremy Siegel, a professor at Wharton, believes stocks can be “constructive” in higher rate environments like we are seeing right now. He does not believe higher rates are bearish for stocks as long as “rates reflect stronger productivity and economic growth.” While the Magnificent 7 stocks are priced to perfection, the forward P/E ratio for the S&P 500 is actually fairly low at approximately 19. Earlier this year we were at 21. Remember, the average P/E for the S&P 500 over time is 15. The lower the P/E ratio, the less expensive the market. How can this be after such a raging bull market from 2023 until today? It all boils down to earnings. Corporate earnings, especially in AI, technology and energy have been very strong as of late. I remember in the late 1990’s everyone and their brother wanted a piece of stock market returns. Many investors threw everything they had, and some threw everything they didn’t have (buying stocks on margin) at the stock market. This action helped increase the stock market bubble. With higher yields, investors will be more likely to take advantage of money markets and CDs – virtual guarantees as opposed to a volatile stock market. Fewer investors buying stocks on margin will hopefully be the result.
Most analysts believe the Federal Reserve will increase rates another ¼ point before the year is complete. That would help anyone invested in the Schwab Prime Advantage Money Market. The yield on this money market is 3.7% – another quarter point would push it close to 4%. CD yields would also go up. Would intermediate and longer-term bonds’ rates also increase? Time will tell. We have not made any drastic changes to our bond allocations because we believe our intermediate bond fund managers are scooping up the higher rates for their bond portfolios. Thus, intermediate bonds might be a good place for yield for the next 2-3 years – just like intermediate bond returns were great in years 2023-2025.
Bottom Line: As long as we see rates stabilize, bonds could do well as bond managers add higher yielding securities to their portfolios and stocks could do well given their relatively lower P/E ratio along with the AI productivity gains many are suggesting will happen in the months and years to come. .
Best regards,
William A. Bullock Curtis J. Leuzinger