Amid all the fear about higher interest rates, we should not forget that they can be–and we think they mostly are–a sign of economic strength. That may sound controversial, but we’ve been here before. In 2022, sharply higher short rates motivated calls of an “inevitable” recession, yet no recession has landed. The U.S. economy has been so strong that it has withstood the blistering path of rate hikes.
Now in 2023, with short rates near their peak, long-term interest rates have continued to move sharply higher, reaching 4.89% in recent days. Is this a sign of stress that finally delivers the long-feared recession? Or is it again a sign of strength that will force a new balancing act for monetary policy but allow U.S. economic expansion to live on? The answer can be found by checking the gloomy narratives and exploring the mechanics of how strength delivers higher rates.
Popular narratives that failed to pan out
As rates have risen, headlines of an impending U.S. debt crisis–and even eventual default–have steadily percolated. Yet, the idea that soaring debt and burgeoning deficits have finally caught up with the U.S. is ill-founded. It is true that debt is soaring and that running large deficits is unwise. However, the narrative of a sovereign debt crisis is incompatible with sustained and significant currency strength. The dollar not only remains exceptionally strong–it has rallied sharply with rising rates. One day, this may be the threat. Today is not that day.
A softer, less gloomy, version of this narrative is that the “bond vigilantes” have returned–bond traders that respond to irresponsible fiscal policy by selling off debt and sending yields higher. Though the vigilantes may be stirring today, they no longer have the kind of power that forced President Jimmy Carter’s budget to be withdrawn in 1980.
It was a broken inflation regime that conferred power on bond vigilantes, specifically unanchored inflation expectations that underpinned the ugly 1970s. Today, inflation expectations are anchored, making the vigilantes’ descendants weaker. Rather than being vetoed by bond markets, policymakers are seeking higher rates–and getting what they want.
Of course, the 1970s have been another popular narrative over the last two years that hasn’t panned out. Rather than breaking the inflation regime, the Fed has broken the inflation fever. Peaking at a fearsome 9.1% in June of 2022, it has fallen to 3.7% in August. And no measures of inflation expectations indicate an unhealthy break higher that would explain surging bond yields.
Although we don’t think it’s primarily about debt and deficits (or the supply of bonds), higher rates may well reflect a different kind of risk premium. They may signal that the insurance value of long-dated bonds has fallen. For a long time, long-dated debt was a reliable hedge against risk: when equities fell, bonds rose (i.e., yields fell). Now that the Fed raised rates to slow the economy, that hedge, known as negative bond-equity correlation in the jargon, has not worked. Portfolio managers who previously paid high prices for bonds because of that insurance value are now less likely to do so, driving up yields.
Higher rates bring risks–but remain a sign of strength
Just as portfolio managers must adjust to the consequences of higher rates, so must firms. Higher rates are often seen only through a lens of risk, such as a cascade of business defaults or more failures in the banking system. These fears should not be dismissed lightly. The rise in business bankruptcies, from Bed Bath and Beyond to Party City, is real (if from very low levels). Likewise, the collapse of SVB early in 2023 showed that the financial system is vulnerable to shifts in the rate environment.
However, we need to remember that financial stress and business failure are the very channels through which monetary policy works. Curtailed credit slows down growth. And bankruptcies lead to a reallocation of resources–particularly labor–to more productive uses. While financial fragility is not the goal, rolling bankruptcies can be seen as part of the objective of tightening monetary policy. Paul Volcker was once asked how monetary policy worked to bring down inflation, “by causing bankruptcies,” he answered.
Real and present microeconomic stress and pain should not obscure the fact that high long rates are a result–and a sign–of macroeconomic strength.
The first driver of high long rates comes from cyclical strength. Markets had mistakenly placed a high probability on a 2023 recession and with it the chance that rates would move quickly lower. As the previously unpopular soft-landing narrative gained traction, the prospect of much lower short rates dimmed. And because long rates reflect expectations of short rates over their horizon (combined with a term premium), this also meant higher long rates.
The second driver reflects structural strength. Despite inflation’s substantial retreat, it will likely remain above the 2% target in the years ahead. This points toward a cautious Fed that will only gradually adjust policy back toward a neutral rate. As a result, short rates will remain higher for longer. Policymakers have been saying this for some time, but markets are starting to believe them.
Third, perceptions of the “neutral” rate are also drifting–upward. Even when inflation gets back to target and policymakers are comfortable lowering the policy rate to neutral, that rate may be higher than recently supposed. While this neutral rate (also called r-star in the jargon) is unknown and is moving around, it is influential on long-term interest rates.
What comes next–and why
Though the shifts in short and long rates reflect different dynamics, they both speak to macroeconomic strength that policymakers are looking to restrain. Pushing the policy rate higher has proven effective (inflation is down), but less than most thought (the recession didn’t arrive). Now, the rise in long rates, which the Fed has less influence over, is the next balancing act.
The economy stands a good chance of muddling along. Growth will prove modest but can remain resilient. Inflation will moderate further but not completely. Monetary policy will eventually look to normalize, but very cautiously. This points toward long rates remaining elevated, and only moderating modestly over the coming years.
Alternatively, if the economy proves too strong, inflation moderation is too modest or even reaccelerates, and today’s high rates prove too little headwind for the strong economy, then rates must move even higher. Yet even that would not necessarily be a sign of economic crisis but rather a reflection of the continued challenges of restraining a strong economy to prevent it from overheating.
Meanwhile, a true recession could always hit, undermining growth and inflation, motivating policy to cut more quickly and more significantly than expected. This would likely move rates down decisively. The degree to which they would fall depends on the mix of how convincingly inflation continues to ease, as well as the severity of the downturn.
But none of these pathways are about debt-driven crisis, structural inflation, or a credit crisis. And while each of those is possible, the shift higher in long rates has not moved them to the center of the risk distribution.
Philipp Carlsson-Szlezak is a managing director and partner in BCG’s New York office and the firm’s global chief economist. Paul Swartz is a director and senior economist at the BCG Henderson Institute in New York.
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