Interest Rates and Stock Prices: An Old Debate Flares up!

    The war in Iran, oil prices and worries about a recession have all taken turns driving stock prices  in 2026 but talk about interest rates and where they are going has been a constant concern all year. In the last few weeks, interest rate worries have come to the surface again, for three reasons, all related. The first is the rise in long-term US treasury rates to levels not seen in twenty years. The second is US debt exceeding $40 trillion for the first time, bringing attention to a long-standing worry that this debt burden may be hitting a tipping point for bond buyers. The third is a that the Federal Reserve has a new chair in Kevin Warsh, and for the many Fed Watchers, who are uncertain about where he plans to lead the Fed, the Federal Open Market Committee (FOMC) meeting coming up in mid-September looms larger than ever. 

    In this post, I hope to step back from the day-to-day coverage of US treasury yields and look at their performance in 2026, not only with a longer term perspective, but also in the context of movements in long terms yields in government bonds in other currencies. I also intend to revisit a discussion that I initiated in 2022, when interest rates were the central act in markets, about the relationship between interest rates and stock prices, and why higher rates do not always translate into lower stock prices, and why that effect will vary across sectors and companies.

Government Borrowing Rates

    Governments borrow money and often do so by issuing bonds in financial markets. The rates on these bonds reflect the concerns that lenders have about the purchasing power of the currencies that they are issued in, and government bond rates, for better or worse, become indicators that drive day-to-day market movements in almost all asset classes. In this section, I will begin with an examination of US treasury rates before expanding the discussion to government bond rates in other currencies.

The 2026 Interest Rate Experience

    Coming into 2026, US treasury rates had mostly moved sideways for a couple of years, but during the course of 2026, rates have risen steadily across the maturity spectrum with long term treasury rates showing more movement than rates at the short end. Both the 20-year and 30-year treasuries rose above 5% during the course of the year, and the 10-year rate, which started the year at 4.18% reached 4.75% at the end of August. The graph below looks at US treasury rates across maturities in 2026:

I know that there are some who attribute almost everything related to interest rates to the Fed, and while I think that is simplistic and wrong-headed to do so, I show the four FOMC meetings that have occurred in 2026, as well as the date of Kevin Warsh’s ascension to the chairmanship of the Fed. While there is little in this graph to indicate that the meetings or the changing of the guard at the top had a material impact on treasury rates, the divergence in rate movement across maturities has removed the kink (at the 2-year maturity) at the start of the year and made the yield curve more upward sloping:

US Treasury Department

A Longer Term Perspective on Interest Rates

    To put the increase in rates, especially long term, during 2026 in context, I looked at movements in 3-month, 10-year and 30-year rates between 1962 and the start of September 2026, with the caveat that the 30-year rate series is available only since the mid-1970s.

Federal Reserve Data (FRED)

As you look at the entire time period, you can see the trauma of the 1970s, a decade where interest rates rose to levels not seen in the US in a century, and peaking in 1981, as the Fed struggled to put the inflation bogeyman back into the closet. While rates did come down from those highs, they stayed in the 8-9% range in the second half of the 1980s, and in the 6-8% range in the 1990s  with the dot-com boom operating as a ballast. In the first decade of this century, ten-year rates declined below 5% in 2002, but stayed in the 4-5% range until 2008, when the financial crises drove rates below 4%. In the last decade (2011-2020), rates trended down, dropping below 3% in 2011 and staying in the 2-3% range for most of the period, with the Fed lending a helping hand. The economic shutdown in 2020, after COVID, pushed long term rates below 1% for the first time in history, and rates stayed low in 2021. The extended stretch of low interest rates from 2009 to 2021 was broken in 2022, when the ten year rate more than doubled, from 1.52% to 3.88%, and rates since have largely stayed in the 4-4.5% range, with the 4.75% rate in September 2026 representing a breakout. The graph also includes the 3-month treasury bill rate, and it moves largely with the 10-year rate, albeit with bigger swings, and rates close to zero for much of the last decade, and the 30-year treasury rate, which has generally traded at slightly above the 10-year rate, with the difference widening in September 2026.

The Drivers of US Interest Rates

    In my prior posts on interest rates, I have argued that the focus among many investors and market-watchers on the Federal Reserve as the all-powerful force moving interest rates has diverted attention from the fundamentals that move rates over time. The first of these fundamentals is inflation, with higher expected inflation manifesting as higher rates, and the second is a real interest rate, which at least in the long term, you can proxy with real growth in the economy. One of the indicators that I track is what term an "intrinsic riskfree rate", which I obtain by summing up the inflation rate and real GDP growth in the US economy each year. Financial markets have minds of their own, and the observed rates are a function of demand and supply:

If your pushback is that actual inflation is a noisy estimate, and that expected inflation is anyone's guess, you are right, but for much of this century, we have had market estimates of expected inflation, that can be obtained from the US treasury market, by comparing the 10-year US treasury yield to the yield on a ten-year US TIPs (inflation-protected rate):

Federal Reserve Data (FRED)

The expected inflation numbers embedded in the US treasury market show a market that is less swayed by year-to-year changes in inflation than more by long term expectations, with a dip in expected inflation between 2008 and 2021, and an increase in expected inflation estimates, starting in 2022.  It is interesting that notwithstanding the surge in oil prices this year, and the increased talk of inflation, there has been only a very mild increase in the long-term expected inflation rate, as calculated using yields on treasuries at the start of September 2026.

    In the graph below, I use the actual inflation rates and real GDP growth rates for the US, going back to 1962, and compute the intrinsic 10-year treasury rate (the cumulative column) and actual 10-year treasury rate each year:

Federal Reserve Data (FRED)

The graph tells the interest rate story well, as the surge in inflation in the 1970s played out as higher rates (intrinsic and real) for much of that decade and the next, and the decline in inflation and anemic real growth translated into the lower rates that we observed from 2009 and 2021. When inflation surged in 2022, interest rates went up, but since the rates that I am tracking are long term rates, the intrinsic risk free rate vastly exceeded the actual rate that year, but the difference has narrowed over time, and almost dissipated by September 2026 (when the US 10-year treasury bond rate was 4.75% and and the intrinsic ten-year rates yielded 5.41%).

Government Bond Rates in Other Currencies (Countries)

   As investors focus on movements in US treasuries, interest rates have been on the move across the globe since 2021. In the graph below, I start with a look at government bond rates in five other currencies: the Euro (with the German 10-year bond rate), the Japanese Yen, the Australian and Canadian dollar and the British pound:

You will notice that the rise in rates from COVID lows (which pushed the Euro ten-year rate into negative territory) has been across the board, with rates surging in 2022. Focusing just on 2026, you see the same pattern, with rates rising across all of the currencies tracked in this graph. What about the currencies of other economies? I track ten-year government rates in four  currencies - the Chinese Yuan, the Indian rupee, the Brazilian Real and the South African Rand - in the graph below:

Here, the results are more nuanced, with no or a muted 2022 effect, and ups and downs since; rates are lower in September 2026 than they were in 2021 in three of the four currencies. 

    The convergence of government bond rates across currencies in the last few years has laid waste to the carry trade, where you borrow money in a low-rate currency and lend it out at a higher-rate currency, and the punishment meted out to its practitioners is, in my view, well deserved. The carry trade is the laziest of investment strategies, with its successes due entirely to lags in how exchange rates respond to fundamentals, and calling it an investment strategy does a disservice to investing, in general.

Interest Rate Ripple Effects

    Changes in government bond rates clearly play out in the pricing of government bonds, and returns you will earn on them, but the ripple effects play out across the rest of the market (financial and real). In this section, I will start with the corporate bond market, where the interest rate effect is dominant, before looking at equities, where interest rate effects are more nuanced. 

Corporate Bonds

    Just as governments need to borrow money to fund their expenditures, businesses also borrow money, either through bank loans or if they are positioned to do so, by issuing bonds. The rates at which businesses can borrow start with a riskfree rate in the currency as a base, with a credit spread reflecting the business borrower's default risk added on. If governments are perceived to be riskfree, the government bond rate stands in as the riskfree rate, but if they are not, the riskfree rate can be extracted from the government bond rate, by netting out the default spread for the government. That makes working with US dollars tricky, since the US lost its Aaa rating (Moody's) in May 2025, and I wrote about the consequences for computing dollar riskfree rates at the time.

   In the graph below, I look at the day-to-day movements in default spreads over the ten-year US treasury rate, across seven bond ratings classes - AAA, AA, A, BBB, BB, B and CCC & lower - in 2026: 

Federal Reserve Data (FRED)

Since default spreads are added to the US treasury rate, and the ten-year rate has risen in 2026 from 4.18% at the start to 4.75% on August 31, 2026, corporate bond rates are all higher than they were at the beginning of the year. For all of the ratings classes, other than high yield (CCC & below), spreads are largely unchanged or lower. The only ratings class where you see a surge in spreads is in the lowest rated bonds, where the default spread has increased by 1.57% during the course of the year.

    The implications for corporate borrowing and costs of capital are direct. Debt is now costlier than it was at the start of the year, for business borrowers across the world, with almost all of the increase coming from rising riskfree rates, in different currencies, with an added cost for the borrowers with the highest default risk. For bond investors, with money in long-term corporate bonds, the year has played out in lower bond prices, in both the treasury and corporate bond markets.

Note that while the returns have been low or even negative, across bond categories, the effect is nowhere near the carnage that we saw in 2022, partly because the rate change has been more muted and partly because the price effect of a rate change is much greater when rates are very low, as they were at the start of 2022.  

Stock Prices

    The essence of intrinsic value is that the value of an asset is the present value of the expected cashflows from that asset. As you take your first steps through discounted cashflow valuation, the question of what should happen to value, as interest rates increase, seems obvious. After all, as interest rates rise, discount rates should go up, and as they go up, the present value should decrease. That is, in fact, the process that I used to estimate the changes in bond value during 2026, in both US treasuries and corporate bonds. The reason that the effect of higher rates on value is direct, with bonds, is because the cash flow on a bond is the coupon and the coupon is set at the time the bond is issued, and does not change as interest rates change. With stocks, the effect of higher interest rates is not as direct for a simple reason. The expected cash flows on stocks are the residual cashflows from operations at businesses, and these residual cash flows reflect the revenues, earnings and reinvestment at these businesses. 

If, as interest rates rise, both cash flows and discount rates change, the effect of interest rates changes on equity prices requires grappling with how these interest rates changes play out in operating metrics:

• With revenues, the key determinants of how higher interest rates play out in value will depend first on why interest rates rose in the first place (higher inflation or higher real rates), and if it is higher inflation, how much pricing power a business has to pass through that inflation to its customers.
• With earnings, the question is how higher interest rates play out in profit margins, through their effects on costs of goods sold (gross), other operating expenses (operating) and interest expenses (net).
• When interest rates rise, and that rise is due more to real rates rising rather than inflation going up, businesses can scale back reinvestment, since fewer investments will generate the returns needed to pass muster. This reduction in reinvestment can increase near-term cashflows, at the expense of future growth.

The effects of higher interest rates will therefore vary across companies, with some companies seeing decreases in value (as the discount rate effect dominates any cash flow effects), some seeing no impact (as the discount rate and cash flow effects cancel out), and some benefiting with higher value, because their cash flows rise more than enough to compensate for higher discount rates:

The effect on equities, in the aggregate, will depend on the composition of the market, and which of the three groups (companies hurt by. not affected by or helped by) dominates. There is the added complication of risk premiums (equity risk premium and bond default spread) being affected by higher rates, adding to the discount rate effect.

As you can see, the question of how higher interest rates will play out in stock prices, will vary across different equity markets, and with any given market, it will vary across time. As US treasuries have risen in 2026, US equity indices have, for the most part, taken that increase in stride, with the S&P 500 and NASDAQ both rising strongly over the first eight months of the year:

To zero in on the interest rate effect, I looked at the yield on the 10-year US treasury bond, by day, during 2026. Of the 169 trading days of the year, from January 1 through August 31, 2026, there have been 84 days when yields increased, 73 days that they decreased and 12 days where they remained unchanged, and I looked at S&P 500 average daily returns for each group:

Were stock prices affected by changes in treasury rates during the trading day in 2026? The answer is yes, but only for larger movements in the yield (>3 basis points), with the S&P 500 down almost half a percent on days when the 10-year rate increased by more than 3 basis points and up about half a percent on days when the rate decreased by more than 3 basis points. Thus, at the risk of sounding contradictory, while stocks have held their own during 2026, in the face of rising rates, they have done much worse on days when the 10-year treasury rate went up than they did on days that rate decreased. The secret to equity resilience in the face of higher oil prices, interest rates and political turmoil has been in equity earnings, which have surged over the course of 2026. In the graph below, you can see the analyst consensus estimates of earnings for the S&P 500 for 2026 and 2027 over the course of 2026: 

Ed Yardeni

Over the first eight months of 2026, analysts who track the S&P 500 companies have raised their estimates for corporate earnings by more than 11% for both 2026 and 2027, indicating that companies are finding ways to get more to the bottom line, in the face of macro concerns and higher rates. I know that you have questions about these earnings, and I do as well, especially in the context of how companies are reporting the effects of AI on their earnings, but at least on the surface, the numbers are impressive. I plan to revisit these earnings numbers in a future post, and take a deeper look at what's driving these numbers, but for the moment, they are the reason that stocks have held their own in 2026.

Equities: Cross Company Comparisons

    While equities, at least in the aggregate, have held their value, how have higher interest rates played out across sectors? In the table below, I break down all US companies, broken down into sectors, and look at the change in aggregate market capitalization for the sector, as well as statistics on individual companies within each sector (lower quartile, median, upper quartile and percent up and down):

Source Data: S&P Capital IQ

During 2026, energy was the best performing sector, not surprising given the spike in oil prices, followed by technology, at least based upon aggregated market cap returns. The divergence between the at measure of return and the returns on the median company in the sector is a measure of how top-heavy a sector's returns are, and with technology, it is clearly the largest tech companies that are driving the returns; the median tech company had returns of only 7.75%, well below the aggregate tech sector returns of 25.22%. The worst performing sectors in 2026, at least through August, are the consumer sectors (discretionary and staple), utilities and communications, with lower pricing power and higher input costs to blame.

   Since the rise in interest rates is not restricted to the United States, I looked at the performance of equities across the globe, based upon aggregated market capitalization (in dollar terms) and looking at individual company metrics on returns:

Source Data: S&P Capital IQ

While global equity value has increased about $17 trillion (11.28%) in 2026 (through August 31, 2026), there are wide differences across regions, with Indian and Chinese equities struggling with low single digit returns, and far more stocks down than up. Some of the performance that you see in this table comes from movements in exchange rates, since regions with currencies that have appreciated (depreciated) against the US dollar will see increases (decreases) in US dollar returns.

Conclusion

    As we get closer to the FOMC meeting date, it is likely that there will more talk about interest rates, and what the Fed can or cannot do to change their course. Much of that debate, in my view, is pointless, since the pathway of rates is and will continue to be set by fundamentals. In fact, the ten-year US treasury rate has been stuck in a fairly tight range, between 4% and 5%, since 2022, and that is largely because expected inflation has settled in at about 2.5%, even as actual inflation has remained volatile. For rates to change significantly, up or down, there has to be a break in inflation expectations, to the up or downside, and there is little that Kevin Warsh or Scott Bessent can do to alter that trajectory. As to how equity markets and businesses are dealing with higher rates, the pain from moving from a low-rate to a high-rate world was most acutely felt in 2022, and both have adapted quickly to the new environment, with businesses finding ways to deliver higher earnings in the face of higher rates, and markets pricing in these earnings to deliver solid returns. 

YouTube Video

Data Links

1. US Treasury Rates, Corporate Bond Spreads and Equities in 2026 (1/1/26-8/31/26)
2. US Treasury Rates: Intrinsic vs Actual 10-year Rates (1954 to 2026)

Data Update 4 for 2025: Interest Rates, Inflation and Central Banks!

It was an interesting year for interest rates in the United States, one in which we got more evidence on the limited power that central banks have to alter the trajectory of market interest rates. We started 2024 with the consensus wisdom that rates would drop during the year, driven by expectations of rate cuts from the Fed. The Fed did keep its end of the bargain, cutting the Fed Funds rate three times during the course of 2024, but the bond markets did not stick with the script, and market interest rates rose during the course of the year. In this post, I will begin by looking at movements in treasury rates, across maturities, during 2024, and the resultant shifts in yield curves. I will follow up by examining changes in corporate bond rates, across the default ratings spectrum, trying to get a measure of how the price of risk in bond markets changed during 2024.

Treasury Rates in 2024

    Coming into 2024, interest rates had taken a rollicking ride, surging in 2022, as inflation made its come back, before settling in 2023. At the start of 2024, the ten-year treasury rate stood at 3.88%, unchanged from its level a year prior, but the 3-month treasury bill rate had climbed to 5.40%. In the chart below, we look the movement of treasury rates (across maturities) during the course of 2024:

Download daily data

During the course of 2024, long term treasury rates climbed in the first half of the year, and dropped in the third quarter, before reversing course and increasing in the fourth quarter, with the 10-year rate ending  the year at 4.58%, 0.70% higher than at the start of the year. The 3-month treasury barely budged in the first half of 2024, declined in the third quarter, and diverged from long term rates and continued its decline in the last quarter, to end the year at 4.37%, down 1.03% from the start of the year. I have highlighted the three Fed rate actions, all cuts to the Fed Funds rate, on the chart, and while I will come back to this later in this post, market rates rose after all three.

    The divergence between short term and long term rates played out in the yield curve, which started 2024, with a downward slope, but flattened out over the course of the year:

Download daily data

Writing last year about the yield curve, which was then downward sloping, I argued that notwithstanding prognostications of doom,  it was a poor prediction of recessions. This year, my caution would be to not read too much, at least in terms of forecasted economic growth, into the flattening or even mildly upward sloping yield curve. 

    The increase in long term  treasury rates during the course of the year was bad news for treasury bond investors, and the increase in the 10-year treasury bond rate during the course of the year translated into an annual return of -1.64% for 2024:

With the inflation of 2.75% in 2024 factored in, the real return on the 10-year bond is -4.27%. With the 20-year and 30-year bonds, the losses become larger, as time value works its magic. It is one reason that I argue that any discussion of riskfree rates that does not mention a time horizon is devoid of a key element. Even assuming away default risk, a ten-year treasury is not risk free, with a one time horizon, and a 3-month treasury is definitely not riskfree, if you have a 10-year time horizon.

The Drivers of Interest Rates

    Over the last two decades, for better or worse, we (as investors, consumers and even economics) seem to have come to accept as a truism the notion that central banks set interest rates. Thus, the answer to questions about past interest rate movements (the low rates between 2008 and 2021, the spike in rates in 2022) as well as to where interest rates will go in the future has been to look to central banking smoke signals and guidance. In this section, I will argue that the interest rates ultimately are driven by macro fundamentals, and that the power of central banks comes from preferential access to data about these fundamentals, their capacity to alter those fundamentals (in good and bad ways) and the credibility that they have to stay the course.

Inflation, Real Growth and Intrinsic Riskfree Rates

    It is worth noting at the outset that interest rates on borrowing pre-date central banks (the Fed came into being in 1913, whereas bond markets trace their history back to the 1600s), and that lenders and borrowers set rates based upon fundamentals that relate specifically to what the former need to earn to cover  expected inflation and default risk, while earning a rate of return for deferring current consumption (a real interest rate). If you set the abstractions aside, and remove default risk from consideration (because the borrower is default-free), a riskfree interest rate in nominal terms can be viewed, in its simplified form, as the sum of the expected inflation rate and an expected real interest rate:

Nominal interest rate = Expected inflation + Expected real interest rate

This equation, titled the Fisher Equation, is often part of an introductory economics class, and is often quickly forgotten as you get introduced to more complex (and seemingly powerful) monetary economics lessons. That is a pity, since so much of misunderstanding of interest rates stems from forgetting this equation. I use this equation to derive what I call an "intrinsic riskfree rate", with two simplifying assumptions:

1. Expected inflation: I use the current year's inflation rate as a proxy for expected inflation. Clearly, this is simplistic, since you can have unusual events during a year that cause inflation in that year to spike. (In an alternate calculation, I use an average inflation rate over the last ten years as the expected inflation rate.)
2. Expected real interest rate: In the last two decades, we have been able to observe a real interest rate, at least in the US, using inflation-protected treasury bonds(TIPs). Since I am trying to estimate an intrinsic real interest rate, I use the growth rate in real GDP as my proxy for the real interest rate. That is clearly a stretch when it comes to year-to-year movements, but in the long term, the two should converge.

With those simplistic proxies in place, my intrinsic riskfree rate can be computed as follows:

Intrinsic riskfree rate = Inflation rate in period t + Real GDP growth rate in period t

In the chart below, I compare my estimates of the intrinsic riskfree rate to the observed ten-year treasury bond rate each year:

Download data

While the match is not perfect, the link between the two is undeniable, and the intrinsic riskfree rate calculations yield results that help counter the stories about how it is the Fed that kept rates low between 2008 and 2021, and caused them to spike in 2022. 

• While it is true that the Fed became more active (in terms of bond buying, in their quantitative easing phase) in the bond market in the last decade, the low treasury rates between 2009 and 2020 were driven primarily by low inflation and anemic real growth. Put simply, with or without the Fed, rates would have been low during the period.
• In 2022, the rise in rates was almost entirely driven by rising inflation expectations, with the Fed racing to keep up with that market sentiment. In fact, since 2022, it is the market that seems to be leading the Fed, not the other way around.
  

Entering 2025, the gap between intrinsic and treasury rates has narrowed, as the market consensus settles in on expectations that inflation will stay about the Fed-targeted 2% and that economic activity will be boosted by tax cuts and a business-friendly administration.

The Fed Effect

    I am not suggesting that central banks don't matter or that they do not affect interest rates, because that would be an overreach, but the questions that I would like to address are about how much of an impact central banks have, and through what channels. To the first question of how much of an impact, I started by looking at the one rate that the Fed does control, the Fed Funds rate, an overnight interbank borrowing rate that nevertheless has resonance for the rest of the market. To get a measure of how the Fed Funds rate has evolved over time, take a look at what the rate has done between 1954 and 2024:

As you can see the Fed Funds was effectively zero for a long stretch in the last decade, but has clearly spiked in the last two years. If the Fed sets rates story is right, changes in these rates should cause market set rates to change in the aftermath, and in the graph below, I look at monthly movements in the Fed Funds rate and two treasury rates - the 3-month T.Bill rate and the 10-year T.Bond rate.

The good news for the "Fed did it" story is that the Fed rates and treasury rates clearly move in unison, but all this chart shows is that Fed Funds rate move with treasury rates contemporaneously, with no clear indication of whether market rates lead to Fed Funds rates changing, or vice versa. To look at whether the Fed funds leads the rest of the market, I look at the correlation between changes in the Fed Funds rate and changes in treasury rates in subsequent months. 

As you can see from this table, the effects of changes in the Fed Funds rate on short term treasuries is positive, and statistically significant, but the relationship between the Fed Funds rate and 10-year treasuries is only 0.08, and barely meets the statistical significance test. In summary, if there is a case to be made that Fed actions move rates, it is far stronger at the short end of the treasury spectrum than at the long end, and with substantial noise in predictive effects. Just as an add on, I reversed the process and looked to see if the change in treasury rates is a good predictor of change in the Fed Funds rate and obtained correlations that look very similar. 

In short, the evidence is just as strong for the hypothesis that market interest rates lead the Fed to act, as they are for "Fed as a leader" hypothesis.

    As to why the Fed's actions affect market interest rates, it has less to do with the level of the Fed Funds rate and more to do with the market reads into the Fed's actions. Ultimately, a central bank's effect on market interest rates stems from three factors:

1. Information: It is true that the Fed collects substantial data on consumer and business behavior that it can use to make more reasoned judgments about where inflation and real growth are headed than the rest of the market, and its actions often are viewed as a signal of that information. Thus, an unexpected increase in the Fed Funds rate may signal that the Fed sees higher inflation  than the market perceives at the moment, and a big drop in the Fed Funds rates may indicate that it sees the economy weakening at a time when the market may be unaware.
2. Central bank credibility: Implicit in the signaling argument is the belief that the central bank is serious in its intent to keep inflation in check, and that is has enough independence from the government to be able to act accordingly. A central bank that is viewed as a tool for the government will very quickly lose its capacity to affect interest rates, since the market will tend to assume other motives (than fighting inflation) for rate cuts or raises. In fact, a central bank that lowers rates, in the face of high and rising inflation, because it is the politically expedient thing to do may find that market interest move up in response, rather than down.
3. Interest rate level: If the primary mechanism for central banks signaling intent remains the Fed Funds rate (or its equivalent in other markets), with rate rises indicating that the economy/inflation is overheating and rate cuts suggesting the opposite, there is an inherent problem that central banks face, if interest rates fall towards zero. The signaling becomes one sided i.e., rates can be raised to put the economy in check, but there is not much room to cut rates. This, of course, is exactly what the Japanese central bank has faced for three decades, and European and US banks in the last decade, reducing their signal power.

The most credible central banks in history, from the Bundesbank in Deutsche Mark Germany to the Fed, after the Volcker years, earned their credibility by sticking with their choices, even in the face of economic disruption and political pushback. That said, in both these instances, central bankers chose to stay in the background, and let their actions speak for themselves. Since 2008, central bankers, perhaps egged on by investors and governments, have become more visible, more active and, in my view, more arrogant, and that, in a strange way, has made their actions less consequential. Put simply, the more the investing world revolves around FOMC meetings and the smoke signals that come out of them, the less these meetings matter to markets. 

Forecasting Rates

    I am wary of Fed watchers and interest rate savants, who claim to be able to sense movements in rates before they happen for two reasons. First, their track records are so awful that they make soothsayers and tarot card readers look good. Second, unlike a company's earnings or risk, where you can claim to have a differential advantage in estimating it, it is unclear to me what any expert, no matter how credentialed, can bring to the table that gives them an edge in forecasting interest rates. In my valuations, this skepticism about interest rate forecasting plays out in an assumption where I do not try to second guess the bond market and replace current treasury bond rates with fanciful estimates of normalized or forecasted rates. If you look back at my S&P 500 valuation in my second data post for this year, you will see that I left the treasury bond rate at 4.58% (its level at the start of 2025) unchanged through time.

     If you feel the urge to play interest forecaster, I do think that it is good practice to make sure that your views on the direction of interest rates are are consistent with the views of inflation and growth you are building into your cash flows. If you buy into my thesis that it is changes in expected inflation and real growth that causes rates to change in interest rates, any forecast of interest rates has be backed up by a story about changing inflation or real growth. Thus, if you forecast that the ten-year treasury rate will rise to 6% over the next two years, you have to follow through and explain whether rising inflation or higher real growth (or both) that is triggering this surge, since that diagnosis have different consequences for value. Higher interest rates driven by higher inflation will generally have neutral effects on value, for companies with pricing power, and negative effects for companies that do not. Higher interest rates precipitated by stronger real growth is more likely to be neutral for the market, since higher earnings (from the stronger economy) can offset the higher rates. The most empty forecasts of interest rates are the ones where the forecaster's only reason for predicting higher or lower rates is central banks, and I am afraid that the discussion of interest rates has become vacuous over the last two decades, as the delusion that the Fed sets interest rates becomes deeply engrained.

Corporate Bond Rates in 2024

    The corporate bond market gets less attention that the treasury bond market, partly because rates in that market are very much driven by what happens in the treasury market. Last year, as the treasury bond rate rose from 3.88% to 4.58%, it should come as no surprise that corporate bond rates rose as well, but there is information in the rate differences between the two markets. That rate difference, of course, is the default spread, and it will vary across different corporate bonds, based almost entirely on perceived default risk. 

Default spread = Corporate bond rate - Treasury bond rate on bond of equal maturity

Using bond ratings as measures of default risk, and computing the default spreads for each ratings class, I captured the journey of default spreads during 2024:

During 2024, default spreads decreased over the course of the year, for all ratings classes, albeit more for the lowest rated bonds. Using a different lexicon, the price of risk in the bond market decreased during the course of the year, and if you relate that back to my second data update, where I computed a price of risk for equity markets (the equity risk premium), you can see the parallels. In fact, in the graph below, I compare the price of risk in both the equity and bond markets across time:

In most years, equity risk premiums and bond default spreads move in the same direction, as was the case in 2024. That should come as little surprise, since the forces that cause investors to spike up premiums (fear) or bid them down (hope and greed) cut across both markets. In fact, lookin a the ratio of the equity risk premium to the default spread, you could argue that equity risk premiums are too high, relative to bond default spreads, and that you should see a narrowing of the difference, either with a lower equity premium (higher stock prices) or a higher default spread on bonds.

    The decline of fear in corporate bond markets can be captured on another dimension as well, which is in bond issuances, especially by companies that face high default risk. In the graph below, I look at corporate bond issuance in 2024, broken down into investment grade (BBB or higher) and high yield (less than BBB). 

Note that high yield issuances which spiked in 2020 and 2021, peak greed years, almost disappeared in 2022. They made a mild comeback in 2023 and that recovery continued in 2024. 

    Finally, as companies adjust to a new interest rate environment, where short terms rates are no longer close to zero and long term rates have moved up significantly from the lows they hit before 2022, there are two other big shifts that have occurred, and the table below captures those shifts:

First, you will note that after a long stretch, where the percent of bond that were callable declined, they have spiked again. That should come as no surprise, since the option, for a company, to call back a bond is most valuable, when you believe that there is a healthy chance that rates will go down in the future. When corporates could borrow money at 3%, long term, they clearly attached a lower likelihood to a rate decline, but as rates have risen, companies are rediscovering the value of having a  calculability option. Second, the percent of bond issuances with floating rate debt has also surged over the last three years, again indicating that when rates are low, companies were inclined to lock them in for the long term with fixed rate issuances, but at the higher rates of today,  they are more willing to let those rates float, hoping for lower rates in future years.

In Conclusion

    I spend much of my time in the equity market, valuing companies and assessing risk. I must confess that I find the bond market far less interesting, since so much of the focus is on the downside, and while I am glad that there are other people who care about that, I prefer to operate in a space where there there is more uncertainty. That said, though, I dabble in bond markets because what happens in those markets, unlike what happens in Las Vegas, does not stay in bond markets. The spillover effects into equity markets can be substantial, and in some cases, devastating. In my posts looking back at 2022, I noted how a record bad year for bond markets, as both treasury and corporate bonds took a beating for the ages, very quickly found its ways into stocks, dragging the market down. On that count, bond markets had a quiet year in 2024, but they may be overdue for a clean up.

YouTube

Data Updates for 2025

1. Data Update 1 for 2025: The Draw (and Danger) of Data!
2. Data Update 2 for 2025: The Party continued for US Equities
3. Data Update 3 for 2025: The times they are a'changin'!
4. Data Update 4 for 2025: Interest Rates, Inflation and Central Banks!
5. Data Update 5 for 2025: It's a small world, after all!
6. Data Update 6 for 2025: From Macro to Micro - The Hurdle Rate Question!
7. Data Update 7 for 2025: The End Game in Business!
8. Data Update 8 for 2025: Debt, Taxes and Default - An Unholy Trifecta!
9. Data Update 9 for 2025: Dividend Policy - Inertia and Me-tooism Rule!

Data Links

1. Intrinsic risk free rates and Nominal interest rates
2. Bond Default Spreads and Equity Risk Premiums

Fed up with Fed Talk? Fact-checking Central Banking Fairy Tales!

     The big story on Wednesday, September 18, was that the Federal Reserve’s open market committee finally got around to “cutting rates”, and doing so by more than expected. This action, much debated and discussed during all of 2024, was greeted as "big" news, and market prognosticators argued that it was a harbinger of market moves, both in interest rates and stock prices. The market seemed to initially be disappointed in the action, dropping after the Fed’s announcement on Wednesday, but it did climb on Thursday. Overall, though, and this is my view, this was about as anticlimactic as a climactic event gets, akin to watching an elephant in labor deliver a mouse.  As a long-time skeptic about the Fed’s (or any Central Bank’s) capacity to alter much in markets or the economy, I decided now would be as good a time as any to confront some widely held beliefs about central banking powers, and counter them with data. In particular, I want to start with the myth that central banks set interest rates, or at least the interest rates that you and I may face in our day-to-day lives, move on to the slightly lesser myth that the Fed's move lead market interest rates, then examine the signals that emanate supposedly from Fed actions, and finish off by evaluating how the Fed's actions affect stock prices.

The Fed as Rate Setter

      As I drove to the grocery story on Fed Cut Wednesday, I had the radio on, and in the news at the top of the hour, I was told that the Fed had just cut interest rates, and that consumers would soon see lower rates on their mortgages and businesses on their loans. That delusion is not restricted to newscasters, since it seems to be widely held among politicians, economists and even market watchers. The truth, though, is that the Fed sets only one interest rate, the Fed Funds rate, and that none of the rates that we face in our lives, either as consumers (on mortgages, credit cards or fixed deposits) or businesses (business loans and bonds),  are set by or even indexed to the Fed Funds Rate. 

    The place to start to dispel the “Fed sets rates” myth is with an understanding of the Fed Funds rate, an overnight intra-bank borrowing rate is one that most of us will never ever encounter in our lives. The Federal Open Market Committee (FOMC) has the power to change this rate, which it uses at irregular intervals, in response to economic, market and political developments. The table below lists the rate changes made by the Fed in this century:

Note that while most of these changes were made at regularly scheduled meetings, a few (eleven in the last three decades) were made at emergency meetings, called in response to market crises. As you can see from this table, the Federal Reserve goes through periods of Fed Funds rate activism, interspersed with periods of inactivity. Since the Fed Funds rate is specified as a range, there are periods where the effective Fed Funds rate may go up or down, albeit within small bounds. To gain perspective on how the Fed Funds rate has been changed over time, consider the following graph, where the effective fed funds rate is shown from 1954 to 2024:

Download data

In addition to revealing how much the Fed Funds rate has varied over time, there are two periods that stand out. The first is the spike in the Fed Funds rate to more than 20% between 1979 and 1982, when Paul Volcker was Fed Chair, and represented his attempt to break the cycle of high inflation that had entrapped the US economy. The second was the drop in the Fed Funds rate to close to zero percent, first after the 2008 crisis and then again after the COVID shock in the first quarter of 2020. In fact, coming into 2022, the Fed had kept the Fed Funds rates at or near zero for most of the previous 14 years, making the surge in rates in 2022, in response to inflation, shock therapy for markets unused to a rate-raising Fed.

    While the Federal Open Market Committee controls the Fed Funds rate, there are a whole host of rates set by buyer and sellers in bond markets. These rates are dynamic and volatile, and you can see them play out in the movements of US treasury rates (with the 3-month and 10-year rates highlighted) and in corporate bond rates (with the Baa corporate bond rate shown).

Download data

There is a final set of rates, set by institutions, and sometimes indexed to market-set rates, and these are the rates that consumers are most likely to confront in their day-to-day lives. They include mortgage rates, set by lenders, credit card rates, specified by the credit card issuers, and fixed deposit rates on safety deposits at banks.  They are not as dynamic as market-set rates, but they change more often than the Fed Funds rate.

Download data

There are undoubtedly other interest rates you will encounter, as a consumer or a business, either in the course of borrowing money or investing it, but all of these rates will fall into one of three buckets - market-set interest rates, rates indexed to market-set rates and institutionally-set rates. None of these rates are set by the Federal Reserve, thus rendering the "Fed sets interest rates" as myth.

Response to comments: It is true that the prime rate remains one of the few that is tied to the Fed Funds rate, and that there is subset of business loans, whose rates are tied to the prime rate. That said, the portion of overall business debt that is tied to the prime rate has declined significantly over time, as variable rate loans have switched to treasury rates as indices, because they tend to be updated and dynamic. It is also true that central-bank set rates can affect a larger subset of rates in some countries, for one of two reasons. The first is that the country has poorly functioning or no bond markets, making market-set rates a non-starter. The second is if the government or central bank can force banks to lend at rates tied to the central bank rate. In both cases, though, the central banking power works only if it is restrained by reality, i.e., the central bank rate reflects the inflation and real growth in the economy. Thus, if inflation is 20%, a central bank that forces lenders to lend at 12% will accomplish one of two objectives - driving lending banks to calamity or drying up the market for business loans.

The Fed as Rate Leader

    Even if you accept that the Fed does not set the interest rates that we face as consumers and businesses, you may still believe that the Fed influences these rates with changes it makes to the Fed Funds rate. Thus, you are arguing that a rise (fall) in the Fed Funds rate can trigger subsequent rises (falls) in both market-set and institution-set rates. At least superficially, this hypothesis is backed up in the chart below, where I brings all the rates together into one figure:

Download data

As you can see, the rates all seem to move in sync, though market-set rates move more than institution-set rates, which, in turn, are more volatile than the Fed Funds rate. The reason that this is a superficial test is because these rates all move contemporaneously, and there is nothing in this graph that supports the notion that it is the Fed that is leading the change. In fact, it is entirely possible, perhaps even plausible, that the Fed's actions on the Fed Funds rate are in response to changes in market rates, rather than the other way around.

    To test whether changes in the Fed Funds rate are a precursor for shifts in market interest rates, I ran a simple (perhaps even simplistic) test. I looked at the 249 quarters that compose the 1962- 2024 time period, breaking down each quarter into whether the effective Fed Funds rate increased, decreased or remained unchanged during the quarter. I followed up by looking at the change in the 3-month and 10-year US treasury rates in the following quarter:

Download data

Looking at the key distributional metrics (the first quartile, the median, the third quartile), it seems undeniable that the "Fed as leader" hypothesis falls apart. In fact, in the quarters after the  Fed Funds rate increases, US treasury rates (short and long term) are more likely to decrease than increase, and the median change in rates is negative. In contrast, in the periods after the Fed Fund decreases, treasury rates are more likely to increase than decrease, and post small median increases. 

    Expanding this assessment to the interest rates that consumers face, and in particular mortgage rates at which they borrow and fixed deposit rates at which they can invest, the results are just as stark.

Download data

In the quarter after the Fed Funds rate increase, mortgage rates and fixed deposit rates are more likely to fall than rise, with the median change in the 15-year mortgage rate being -0.13% and the median change in the fixed deposit rate at -0.05%. In the quarter after the Fed Funds rate decreases, the mortgage rate does drop, but by less than it did during the Fed rate raising quarters. In short, those of us expecting our mortgage rates to decline in the next few months, just because the Fed lowered rates on Wednesday, are being set up for disappointment. If you are wondering why I did not check to see what credit card interest rates do in response to Fed Funds rate changes, even a casual perusal of those rates suggests that they are unmoored from any market numbers.

    You may still be skeptical about my argument that the Fed is more follower than leader, when it comes to interest rates. After all, you may say, how else can you explain why interest rates remained low for the last decades, other than the Fed? The answer is recognizing that market-set rates ultimately are composed of two elements: an expected inflation rate and an expected real interest rate, reflecting real economic growth. In the graph below, which I have used multiple times in prior posts, I compute an intrinsic risk free rate by just adding inflation rate and real GDP growth each year:

Download data

Interest rates were low in the last decade primarily because inflation stayed low (the lowest inflation decade in a century) and real growth was anemic. Interest rates rose in 2022, because inflation made a come back, and the Fed scrambled to catch up to markets, and most interesting, interest are down this year, because inflation is down and real growth has dropped. As you can see, in September 2024, the intrinsic riskfree rate is still higher than the 10-year treasury bond rate, suggesting that there will be no precipitous drop in interest rates in the coming months.

Response to comments: Some readers are suggesting a plausible, albeit convoluted, rationale for this result that preserves the Fed Delusion. In a version of 4D chess, they argue that investors in bond markets are largely in the business of forecasting what the Fed will do and that market rates move ahead of Fed actions. Besides being extraordinarily unhealthy for bond investing, if this is in fact what it is happening, there are four problems with this reasoning, First, bond markets pre-date central banks setting rates, and they seemed to do a reasonably good job before the Fed Funds rate was around. In fact, I started in investing in the 1980s, when the Fed went into hibernation on the Fed Funds rate, and trust me when I say the bond market did not miss a beat. Second, if the entire point of bond investing is forecasting what the Fed will do, how would you explain the rise in treasury bill and bond rates in the first half of 2024 (just to give one instance), when all the talk was about the Fed cutting rates, not raising them? Third, if bond markets exist to bet on Fed movements, when the Fed moves unexpectedly (by raising or lowering rates more than expected), there should be an immediate adjustment in the bond market? Thus, last week, when the consensus was that a 25 basis point cut was more likely than a 50 basis point one, there should be have a significant drop in treasury rates in the days after, and there was not. 

The Fed as Signalman

    If you are willing to accept that the Fed does not set rates, and that it does not lead the market on interest rates, you may still argue that Fed rate changes convey information to markets, leading them to reprice bonds and stocks. That argument is built on the fact that the Fed has access to data about the economy that the rest of us don't have, and that its actions tell you implicitly what it is seeing in that data. 

    It is undeniable that the Federal Reserve, with its twelve regional districts acting as outposts, collects information about the economy that become an input into its decision making. Thus, the argument that Fed actions send signals to the markets has basis, but signaling arguments come with a caveat, which is that the signals can be tough to gauge. In particular, there are two major macroeconomic dimensions on which the Fed collects data, with the first being real economic growth (how robust it is, and whether there are changes happening) and inflation (how high it is and whether it too is changing). The Fed's major signaling device remains the changes in the Fed Funds rate, and it is worth pondering what the signal the Fed is sending when it raises or lowers the Fed Funds rate. On the inflation front, an increase or decrease in the Fed Funds rate can be viewed as a signal that the Fed sees inflationary pressures picking up, with an increase, or declining, with a decrease. On the economic growth front, an increase or decrease in the Fed Funds rate, can be viewed as a signal that the Fed sees the economy growing too fast, with an increase, or slowing down too much, with a decrease. These signals get amplified with the size of the cut, with larger cuts representing bigger signals.

    Viewed through this mix, you can see that there are two contrary reads of the Fed Funds rate cut of 50 basis points on Wednesdays. If you are an optimist, you could take the action to mean that the Fed is finally convinced that inflation has been vanquished, and that lower inflation is here to stay. If you are a pessimist, the fact that it was a fifty basis point decrease, rather than the expected twenty five basis points, can be construed as a sign that the Fed is seeing more worrying signs of an economic slowdown than have shown up in the public data on employment and growth. There is of course the cynical third perspective, which is that the Fed rate cut has little to do with inflation and real growth, and more to do with an election that is less than fifty days away. In sum, signaling stories are alluring, and you will hear them in the coming days, from all sides of the spectrum (optimists, pessimists and cynics), but the truth lies in  the middle, where this rate cut is good news, bad news and no news at the same time, albeit to different groups.

Response to comments: Fed rate change signals, as I mentioned, are tough to read. If you have strong priors on the Fed having power to drive markets, you can always the benefit of hindsight to bend the signal to match your priors. 

The Fed as Equity Market Whisperer

    It is entirely possible that you are with me so far, in my arguments that the Fed's capacity to influence the interest rates that matter is limited, but you may still hold on to the belief that the Fed's actions have consequences for stock returns. In fact, Wall Street has its share of investing mantras, including "Don't fight the Fed", where the implicit argument is that the direction of the stock market can be altered by Fed actions. 

    There is some basis for this argument, and especially during market crises, where timely actions by the Fed may alter market mood and momentum. During the COVID crisis, I complimented the Fed for playing its cards right, especially so towards the end of March 2020, when markets were melting down, and argued that one reason that market came back as quickly as they did was because of the Fed. That said, it was not so much the 100 basis point drop in the Fed Funds rate that turned the tide, but the accompanying message that the Federal Reserve would become a backstop for lenders to companies that were rocked by the COVID shutdown, and were teetering on the edge. While the Fed did not have to commit much in capital to back up this pledge, that decision seemed to provide enough reassurance to lenders and prevent a host of bankruptcies at the time.

    If you remove the Fed's role in crisis, and focus on the effects of just its actions on the Fed Funds rate, the effect of the Fed on equity market becomes murkier. I extended the analysis that I did with interest rates to stocks, and looked at the change in the S&P 500 in the quarter after Fed Funds rates were increased, decreased or left unchanged:

Download data

The S&P 500 did slightly better in quarters after the Fed Funds rate decreased than when the rate increased, but reserved its best performance for quarters after those where there was no change in the Fed Funds rate. At the risk of disagreeing with much of conventional wisdom, is it possible that the less activity there is on the part of the Fed, the better stocks do? I think so, and stock markets will be better served with fewer interviews and speeches from members of the FOMC and less political grandstanding (from senators, congresspeople and presidential candidates) on what the Federal Reserve should or should not do.

Response to comments: Here again, the 4D chess argument comes out, where equity markets are so clever and forward-looking, they already incorporate what the Fed will do. Without realizing it, you are making my case that when discussing equity markets and where they will go in the future, we should spend less time talking about what the Fed will do, might do or has not done, since if your premise about markets as forecasting machines is right, it is already in prices.

The Fed as Chanticleer

    If the Fed does not set rates, is not a interest rate driver, sends out murky signals about the economy and has little effect on how stocks move, you are probably wondering why we have central banks in the first place. To answer, I am going to digress, and repeat an ancient story about Chanticleer, a rooster that was anointed the ruler of the farmyard that he lived in, because the other barnyard animals believed that it was his crowing every morning that caused the sun to rise, and that without him, they would be destined for a lifetime of darkness. That belief came from the undeniable fact that every morning, Chanticleer's crowing coincided with sun rise and daylight. The story now takes a dark turn, when one day, Chanticleer sleeps in and the sun rises anyway, revealing his absence of power, and he loses his place at the top of the barnyard hierarchy. 

    The Fed (and every other central bank) in my view is like Chanticleer, with investors endowing it with powers to set interest rates and drive stock prices, since the Fed's actions and market movements seem synchronized. As with Chanticleer, the truth is that the Fed is acting in response to changes in markets rather than driving those actions, and it is thus more follower than leader. That said, there is the very real possibility that the Fed may start to believe its own hype, and that hubristic central bankers may decide that they set rates and drive stock markets, rather than the other way around. That would be disastrous, since the power of the Fed comes from the perception that it has power, and an over reach can lay bare the truth. 

Response to comments: My comments about the Fed being Chanticleer have been misread by some to imply that central banks do not matter, and Turkey (the country, not the Thanksgiving bird) seems to constantly come up constantly as an example of why central banks matter. Again, you are making my case for me. There is nothing more dangerous to an economy than a central bank that thinks it has the power to override fundamentals and impose its preferred interest rates in the economy. The Turkish central bank, perhaps driven by politics, seems to think that the solution to high interest rates (which are being driven by inflation) is to lower the rates that it controls. Not surprisingly, those actions increase expected inflation, and drive rates higher.... (see definition of insanity..)

Conclusion

    I know that this post cuts against the grain, since the notion that the Fed has superpowers has only become stronger over the last two decades. Pushed to explain why interest rates were at historic lows for much of the last decade, the response you often heard was "the Fed did it". Active investors, when asked why active investing had its worst decade in history, losing out to index funds and to passive investors, pointed fingers at the Fed. Market timers, who had built their reputations around using metrics like the Shiller PE, defended their failure to call market moves in the last fifteen years, by pointing to the Fed. Economists who argued that inverted yield curves were a surefire predictor of recessions blamed the Fed for the absence of a recession, after years of two years plus of the phenomena. 

    I believe that it is time for us to put the Fed delusion to rest. It has distracted us from talking about things that truly matter, which include growing government debt, inflation, growth and how globalization may be feeding into risk, and allowed us to believe that central bankers have the power to rescue us from whatever mistakes we may be making. I am a realist, though, and I am afraid that the Fed Delusion has destroyed enough investing brain cells, that those who holding on to the delusion cannot let go. I am already hearing talk among this group about what the FOMC may or may not do at its next meeting (and the meeting after that), and what this may mean for markets, restarting the Fed Watch. The insanity of it all! 

YouTube Video

Data

1. Fed Funds Rates, Treasury Rates and Other Market Interest rates - Historical
2. Intrinsic treasury bond rates