Everyone Is Watching the Wrong Interest Rate
In this week’s Making Sense with Ed Butowsky, I take you inside why the Federal Reserve cutting rates does not mean all interest rates go lower.
Everybody gets excited when the Federal Reserve starts talking about cutting interest rates. Headlines explode, markets react, and investors immediately assume lower rates are coming across the board.
That is not how it works.
The Federal Reserve only directly controls short-term rates like the fed funds rate and the discount rate. Those are the rates banks use to borrow from the Federal Reserve and from each other. What the Fed does not directly control are long-term treasury rates like the 10 year, 20 year, and 30 year treasury yields.
That distinction matters a lot more than most people realize.
When bond yields go lower, bond prices move higher. When bond yields go higher, bond prices fall. That relationship is one of the foundational concepts investors need to understand because it impacts everything from stock valuations to real estate to highly leveraged sectors of the market.
Right now, the yield curve is telling an important story.
On the short end, rates have started to come down. The one-month treasury is sitting around the area where the Fed has the most influence. The government uses those short-term rates to either slow the economy down or stimulate it. If inflation is running hot, they raise rates to cool things off. If economic growth slows, they lower rates to encourage borrowing and spending.
But while short-term rates have eased, long-term rates have continued moving higher.
The 10 year treasury remains elevated, and there is an even larger jump when you move out to the 20 year and 30 year treasury yields. That tells me traders and institutions are pricing in stronger inflationary pressures over the long term, even if inflation appears more controlled in the short-term.
And that is where investors need to pay attention.
A lot of investments are extremely sensitive to long-term interest rates, not short-term Fed cuts. When the cost of borrowing rises, companies that rely heavily on debt begin to feel pressure quickly.
Biotech is a perfect example.
Many biotech companies borrow enormous amounts of money to fund research, development, and operations. As long-term treasury yields rise, the cost of capital rises with them. That squeezes earnings and hurts valuations. You can see that relationship clearly when comparing biotech indexes like LABU against the movement of the 30-year treasury. As long term yields climbed, biotech valuations came under pressure.
And biotech is not alone.
Business development companies, floating rate senior notes, utilities, and REITs are all heavily impacted by long-term interest rates. Investors often celebrate the idea of rate cuts without realizing that the part of the curve driving many of these investments is still moving higher.
That creates a major challenge for stock valuations overall.
There is a very strong relationship between the 10 year treasury yield and how stocks are valued. If the 10 year treasury moves above 5 percent, valuations across the market can compress very quickly. Stocks suddenly become much more expensive relative to safer fixed-income alternatives.
That is the real concern right now.
I am not overly worried about earnings. Expectations have already been reduced, which means many companies will likely meet or exceed those expectations. The bigger variable is interest rates, specifically what happens on the long end of the curve.
Geopolitical tensions in the Middle East are also adding another layer of inflationary pressure, which makes it less likely we see aggressive short-term rate cuts anytime soon.
So while everybody watches the Fed, I am spending just as much time watching the 10-year treasury.
Because that is where the market may be telling the real story.
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