Sarah Hansen: Welcome to Investing Insights. I’m your host Sarah Hansen, and I’m filling in for Ivanna Hampton today.
The November election triggered a steep selloff in longer-term bonds, with yields on the 10-year Treasury note climbing as high as 4.45%. Fixed-income markets have since stabilized, but yields remain significantly higher than their September lows.
We have Morningstar Investment Management’s chief multi-asset strategist Dominic Pappalardo to help us unpack what’s going on and what might be ahead in 2025. Here’s our conversation.
All right. Welcome, Dom. Thanks so much for being here.
Dominic Pappalardo: Thanks, Sarah. Good to be here with you.
Why Did Bond Yields Rise in the Wake of the Election?
Hansen: Great. Can you tell us first, maybe let’s start with the news. Why did bond yields rise so much in the wake of the election last month?
Pappalardo: Sure, Sarah. There are two main issues investors were worried about. The first was the potential for inflation to resurface, both from a supply-side perspective and a demand-side perspective. The supply side would be from potential tariffs that Trump has talked about. Tariffs by definition raise prices which could lead to inflation. The second demand side is from decreased tax rates, both for wage earners as well as business owners, which will impact the demand side, certainly. Both of those could potentially push yields higher.
The second factor is more structural, which is potentially higher borrowing rates for the US government as they have to issue more debt to fund those tax rates that I mentioned. At some point, bond investors will demand more yield or more compensation for risk if the government has to continue to issue more and more debt. They’re still very unlikely to default, but at some point, investors will want more compensation as debt levels continue to increase.
How Investors Are Thinking About Rising Bond Yields
Hansen: Right. It sounds like investors have a certain state of mind when bond yields are rising. What does that thinking look like, and what does it tell you or tell us about what they expect in the future?
Pappalardo: The higher bond yields really focus around the lingering concerns of inflation, in my view. These concerns have definitely escalated post-election. There’s no doubt that Trump continues to discuss tariffs, things of that nature. It’s also quite likely that policy does get enacted because it really only requires White House support for that to happen, so I think that’s the main driving force behind the post-election runup in bond yields.
Additionally, from a macroeconomic view, the higher yields do suggest some belief that we’ll avoid recession. If you go back to 2022 and parts of 2023, there was a growing narrative that we were likely to see an economic downturn. That really never materialized. And as such, interest rates have been able to move up or at least remain higher. If we were to start to see weaker economic data, I would expect bond yields to come down accordingly on the heels of that news.
What the Current Runup in Bond Yields Tells Us About the Markets
Hansen: Interestingly, that’s actually happened a little bit in the wake of the last couple of weeks. As of today, we’re on Wednesday, Dec. 4, the yield on the 10-year Treasury is about 4.2%, give or take a little bit. Is what you just described happening? What does that say about the market?
Pappalardo: I think it might mean that the initial reaction was a bit overdone to the election. This comes back to Morningstar’s philosophy where it’s really important for investors to look past these short-term, week-to-week, or month-to-month market moves and focus on long-term investment strategy. Higher bond yields can be positive for investors using diversified portfolios. Bonds are now in a place where they offer benefits in multiple ways. First, they now offer positive real yield, which means that the income they generate is higher than the inflation rate. So, even after inflation, investors are technically making money by investing in bonds. That had not been the case for 2022 and 2023.
That’s true in the US, but there are even bigger examples globally. And for investors who could consider moving into emerging-markets debt from countries like Brazil and Mexico, where their local bond yields are over 13% and over 10% against a local inflation there of about 4%, there’s really an opportunity to increase value in fixed-income portfolios. Obviously, those emerging markets come with more risk than US Treasuries, but again, in a diversified structure, it could have a place.
How Do Today’s Yields Compare With History?
Hansen: You mentioned the long-term view, which is something that Morningstar is very big on. What about history more broadly? There’s been a lot of talk about how yields are rising, rising, rising, but where are we situated over the span of decades rather than the span of months?
Pappalardo: Sure. It’s a really great point, Sarah, and I think recently, current investors’ views have been artificially biased to where rates have been for the last two decades. They’ve been historically low. Today’s rates are basically on top of long-term averages, maybe even a touch below them depending on what part of the yield curve you look at. So, I think the public perception is that rates have gone up substantially. But if you look back more than 20 years, you could see we’re right around long-term averages. What is different today is the shape of the yield curve. Traditionally, as investors buy longer-dated bonds, they receive more yield to compensate them for the longer time to maturity.
Right now, the yield on the two-year, 10-year, and 30-year Treasuries are all roughly the same, about 4.2% to 4.4%, so there really is no incremental yield advantage to extending your maturity profile. That’s even different than where we were in 2022 and 2023, where the yield curve was actually inverted, meaning short-term yields were higher than long-term yields, a highly unusual situation. The result of that was many investors had begun hoarding cash because cash yields were higher than longer-term Treasury yields, and we really think now is a good time to move out of cash and add some longer-term fixed-income exposure to your portfolios.
Will the Flat Yield Curve Start to Steepen?
Hansen: You mentioned, so we’re not inverted, we’re not on a super steep yield curve right now. We’re flat. This is a good time to talk about the future, 2025. Do you expect a steeper curve? What are you looking ahead to over the next couple of quarters?
Pappalardo: It’s unusual for the curve to be as flat as it is and stay here for any length of time. Flat yield curves are generally an inflection point for interest-rate policy changing or economic shifts. So, we think going into 2025, short-term rates will continue to fall based on additional Fed cuts, which should cause steepening of the yield curve. That could be compounded by the inflation concerns we talked about earlier where long-term interest rates would be most impacted if the market starts to be fearful of inflation again. So, we don’t think it’ll stay here. We think it’s likely to steep in the near future.
Hansen: And steepening again means that long-term rates, like 10-year and out are going to be rising in 2025?
Pappalardo: Sure. Rising, or you could have the opposite where they stay the same and short-term yields come down, but the difference between long-term and short-term will increase.
How Bond Yields Affect the Stock Market
Hansen: Great. I’d love to talk about the relationship between fixed-income markets and the bond yields we’re talking about and the stock market. We’ve seen big changes in the bond market over the last couple of months. What does that mean for equities and for equity investors?
Pappalardo: It’s a difficult question to answer with a blanket statement. It tends to be more focused by sectors or industries within the stock market. For example, banks could benefit from higher rates, more specifically that steeper yield curve we talked about. The function of banks is to borrow capital at short-term rates and lend it out to customers at longer-term rates. As that differential increases, it flows through to their profit margin, so they’re an example where they could benefit from higher interest rates. Other sectors such as real estate or utilities have the opposite effect, where they’re subject to the additional borrowing costs of higher interest rates and therefore their earnings could suffer if interest rates continue to rise.
Additionally, thinking about different components of the equity market, small caps tend to have an outsize negative impact from higher interest rates, mostly because their borrowing is done generally through banks in floating-rate vehicles, whereas large caps can issue fixed-rate debt in public markets and lock in rates when they’re low or more attractive. As such, we think small caps will underperform in a higher interest-rate environment as opposed to large caps based on their borrowing structure.
Hansen: Makes sense. It seems like that interest-rate sensitivity is a two-way street.
Pappalardo: Yes.
How Long Can the Market Withstand a Higher Interest-Rate Environment?
Hansen: Is there any danger to the broader market if rates stay high for a long time? Are there worries about how long the market can withstand that kind of environment?
Pappalardo: Sure. At some point, higher borrowing costs have a negative impact across corporate earnings as a general statement. However, if rates remain high, there’s a good chance that the economy is also doing well. Perhaps some of those companies could offset the higher borrowing costs by increased sales or potentially price increases to their customers. There are ways for them to mitigate it, but yes, if rates stay abnormally high for some length of time, corporate earnings would be negatively impacted by that.
How Bond Yields Affect Mortgages
Hansen: And then, what about other areas of the economy? Higher yields not only affect fixed-income investors and equity investors, but they also interestingly trickle out to other places and other unexpected areas, like mortgages is one we’ve seen recently. Can you talk a little about that relationship and what weird thing is happening?
Pappalardo: There’s no doubt that consumer borrowing rates are impacted by bond market rates. You’re absolutely correct. Mortgages, in your example, generally follow the 10-year Treasury rate, so they’re more susceptible to long-term rate volatility as opposed to the short-term movements that the Fed is dictating. That could be good or bad depending on what happens to the shape of the yield curve. Fortunately, for current homeowners, rates were really low for a long period of time. So, many of them were able to refinance and lock in loans that historically attractive rates at 3% or less.
Conversely, today’s homebuyers don’t have that luxury and they’re paying between 6.5% and 7.5% on average to borrow money for home purchases. So, a substantial difference when you compound that over a 15-year or 30-year time period for a mortgage. Other rates like car loans, for example, that affect consumers are more tied to those short-term rates and perhaps don’t necessarily feel the impact as much as mortgage borrowers do. And with things like car loans, the manufacturers can offer incentives and perhaps buy down those rates and still make it appealing for their customers and ensure that they’re as affordable as possible regardless of the interest-rate environment.
Hansen: Right. Those shorter-term rates follow the Fed more closely.
Pappalardo: Yes.
Hansen: Is that right? Whereas the longer-term rates are a little less connected?
Pappalardo: That’s fair. A typical market adage is that the Fed controls interest rates two years and in, and the “market,” however you want to define that, controls rates 10 years and longer.
How Today’s Bond Yields Can Benefit Investors When Looking at Portfolio Construction
Hansen: Makes sense. Looking big picture, what’s most important for investors to remember when we’re in an environment where yields are maybe higher than they’ve been or they’re rising on the back of political news or anything like that? What should people keep in mind?
Pappalardo: As we discussed earlier, today’s yield environment offers some real benefits when thinking about overall portfolio construction. I think that’s the major takeaway for investors today. That being said, it’s important not to just always chase the highest-yielding investments that are out there. Different asset classes across high yield are valued in different ways. Most of our commentary today focused on US Treasury markets and Treasury rates. But other asset classes within fixed income, like credit, both investment-grade and high-yield, mortgage-backed securities, foreign bonds, all can have a place and be viable options of a diversified portfolio. However, we believe the current valuations and some of those other asset classes really suggest investors should be cautious.
Looking at high yield, for example, credit spreads are very rich. And what I mean by credit spreads, I’m referring to the incremental yield that an investor earns over and above government bonds, and the compensation they’re receiving today for that additional credit risk is very, very low historically. Current yield spreads are roughly in the fifth percentile historically, so they’ve only been lower than this 5% of the time over history, which is definitely not appealing. They’re currently about 2.6% over Treasury bonds for high-yield corporate bonds, which, again, is not something that we think is adequate to justify the additional credit risk that comes along with it.
So, I think I would just reinforce the idea that diversified portfolio construction offers many ways to take advantage of the higher-yield environment we’re in today. We’re back to a point where traditional government bonds or high-quality bonds can offer that hedge value in a diversified portfolio, meaning that if we do enter a period of economic downturn and equity allocations suffer, Treasury bonds do actually have a chance for yields to come down and deliver some incremental price appreciation that way, which has not been the case for most of the last two decades.
Hansen: It sounds like rising yields are not always bad news, but maybe it makes sense to take a closer look rather than painting with a super broad brush.
Pappalardo: Absolutely. In a lot of ways, rising yields are short-term pain that do provide longer-term benefits from an investor perspective.
Economic Outlook 2025 Key Takeaways
Hansen: Any final comments on 2025, the year ahead? We’ll have a new administration, we’ll have some changes in the economy, I’m sure. What’s the takeaway there for investors?
Pappalardo: A totally fair question but difficult to answer. A couple of themes we’ve been focusing on. One is the move out of cash into longer-term fixed income for many of the reasons we’ve discussed today. That appears to be a prudent trade for investors to make. Secondly is just to be prepared for some level of volatility. Certainly with the political regime changing, the Fed shifting gears and moving toward a cutting regime, a lot of unknown factors right now. So, it’s very likely we do see some surprises in 2025 and would just encourage investors to not panic and be expecting some of that over the short term here.
Hansen: Makes sense. Well, thank you, Dom, so much for shedding some light on this for us and for chatting on the podcast today.
Pappalardo: Thanks, Sarah. It’s good to be here with you.
Hansen: That wraps up this week’s episode. Thanks for watching and making this show part of your day. Subscribe to Morningstar’s YouTube channel to see new videos about investment ideas, market trends, and analyst insights. Thanks to senior video producer Jake VanKersen and associate multimedia editor Jessica Bebel. I’m Sarah Hansen, markets reporter at Morningstar.
The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar's editorial policies.
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