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In just six months, the Federal Reserve has hiked interest rates by 300 basis points in one of the fastest rate increases in decades. By the end of 2023, rates could rise to 4.50-4.75% yet, in spite of these increases, rates still fall below historical averages.
In Part 1 of our Seizing Capital Opportunities series from Citizens, we show interest rate trends over modern history, and the implications of increasingly hawkish monetary policy in today’s environment. (In Part 2 of the Seizing Capital Opportunities series, we look at companies that have an advantage during an inflationary environment, and those that may suffer.)
Below, we show average annual 10-year Treasury yields, a proxy for U.S. interest rates, and their annual percentage change since 2013. Data is as of October 5, 2022.
Over the last four decades, the highest average annual interest rate was 13.9% in 1981, while the lowest was 0.9% in 2020.
Benefits and Drawbacks
As interest rates rise from historic lows, what are the advantages and disadvantages of the current environment?
| Pros | Cons |
|---|---|
| Strong labor market with 3.5% unemployment rate | 2 successive quarters of negative GDP growth |
| Real interest rates historically low | 8.2% inflation |
| Businesses with pricing power better equipped to maintain borrowing capacity |
Inverted Treasury yield curve |
On one hand, real interest rates remain near historic lows. After falling negative in 2021, 10-year real interest rates hover around 1.2%. Meanwhile, unemployment rates are below historical averages. As of August, there were about two job openings for every unemployed person.
In today’s environment, businesses with pricing power will likely be more resilient to maintain borrowing capacity and healthier margins.
On the other hand, as interest rates rise, it becomes more expensive for firms to access corporate debt as lending conditions become more constricted.
Spillover Effects of Rising U.S. Interest Rates
As U.S. interest rates have increased, market participants have become increasingly pessimistic of the near-term economic outlook.
Consequently, the yield on short-term U.S. bonds has risen since near-term risks appear greater than risks in the long term. The 10-year minus 2-year Treasury yield curve, which subtracts short-term bond yields from longer-term yields, illustrates this trend.
In October, the Treasury yield inverted to -0.39 basis points, one of the lowest points in decades.
When this yield curve inverts, meaning short-term yields are higher than long-term yields, it often signals market uncertainty. Historically, this has signaled a recession, but often with a several-month lag.
What are The Implications for Businesses?
Years of ultra-low interest rates have supported profit growth and more accommodative lending conditions. As interest rates rise, debt costs will increase, putting a strain on firms’ bottom lines, especially for companies with floating-rate debt.
Additionally, as companies look to refinance debt, borrowing costs will become higher.
The good news is that companies borrowing at fixed rates will be better positioned. Middle market private equity firms—those that acquire companies valued between $50 and $500 million—have seen revenues increase 12% compared to the third quarter of last year, although profit margins have begun declining.
In turn, companies with strong pricing power, improving cost management, and the ability to pass on rising costs to customers will be better able to navigate today’s uncertain environment. Given the number of variables at play, firms that adapt quickly could have greater resilience. 9In Part 2 of the Seizing Capital Opportunities series, we look at companies that have an advantage during an inflationary environment, and those that may suffer.)
The original article/infographic by Dorothy Neufeld has been edited ([ ]) and abridged (…) for the sake of clarity and brevity to provide the reader with a fast and easy read.