The more we learn, the less we know is a sentiment championed by philosopher Socrates.    

With that self-deprecating theme in mind, this article will expand on the inflation topic from last month and look to connect it to the overall interest rate environment. 

The Federal Reserve continues to hold the idea that their inflation target is 2%. Those of us watching from the cheap seats know it has been above that level for five years running with more on the horizon. At what point does this 2% target level lose its efficacy?  

I don’t know the answer to the question, but I do know that the rising inflation environment goes well beyond current messaging that says inflation is higher because energy prices are higher and energy prices are higher because of the war. I wish it were that simple. As you may have guessed, connecting the dots is much more complex. 

Inflation is one of the more visual catalysts that can affect the interest rate environment. Inflation erodes the purchasing power of a dollar, so it is understandable that investors want a yield on fixed income investments (bonds) above the inflation rate. The higher inflation goes, the higher bond yields go. The higher yields go, the more borrowers have to pay for loans. That goes for the U.S. government, corporate borrowers, home loans, car loans, credit cards, you name it.

Even this is an overly simplistic explanation for rising interest rates because this holds true if inflation is more permanently elevated. If it was considered temporary or short term, it may not have any impact on interest rates at all.

What about other catalysts affecting interest rates that are significant but less obvious? The supply of bonds is one of these. The federal government is adding nearly $2 trillion of debt per year. When the supply of bonds exceeds the amount of money investors are looking to put into bond purchases, the interest rate needs to rise to attract more investors until the level balances out. This goes for corporate bonds, mortgage bonds, asset backed bonds, municipal bonds, etc.

Another catalyst is return on invested capital. If a corporation expected to have a return on capital of 4% for a new business line they are considering, they would not issue bonds with an interest rate above 4% because they would lose money on the project (in reality, they likely would not even engage the project at all). But let’s say they expect to have a return of 14%. Issuing bonds at 5% to finance part of the deal would be a consideration. With firms competing for AI dominance, this is the case. These firms are expecting great return on invested capital and are issuing bonds to finance a portion of this build-out. Again, the interest rate must rise enough to attract investors to purchase all the bonds being issued.

There are more reasons, but my goal is to keep these monthly reports to one page and I’m quicky running out of space. I hope this helps expand upon the current commentary that energy prices and the war are the only factors affecting interest rates.

Thank you for your business and confidence in Bell!

Greg Sweeney is the Chief Investment and Economic Strategist at Bell Institutional Investment Management. He guides the investment strategy, and this outlook is his perspective on the latest market trends and what they could mean for investors. Any views, strategies or products discussed in this article may not be appropriate or suitable for all individuals and are subject to risks.