The stock market, as represented by the S&P 500 index, had a relatively good month in February being up nearly 3%. However, the market has been on a downward trajectory over the last couple of weeks, mostly due to investors being spooked by rapidly rising interest rates.

The ten-year Treasury bond yield has risen quickly from about 0.9% at the end of 2020 to about 1.5% at the end of February. The main reasons appear to be increased economic growth and inflation expectations. With the optimism for economic growth this year, investors are demanding higher yields to compensate for the risk of rates rising further (and their bonds falling in price).

GDP (gross domestic product) forecasts are being revised higher for the year, driven by continued fiscal stimulus programs and the recently accelerated rollout of COVID-19 vaccines.

Inflation expectations over the next five years have risen to about 2.5% on an annual basis for the first time since 2008, according to Bloomberg.

The Federal Reserve does not appear to be too concerned at the moment. They had previously announced they would not increase rates until 2023 at the earliest. They have also indicated they will let inflation “run hot” above their 2% long-term target for an extended period of time before taking action.

Federal Reserve Chair Jerome Powell reiterated this stance on Thursday, March 4, saying that increased inflation for the rest of the year would not cause their long-term inflation expectations to change.

It was very predictable that interest rates would be rising after they fell to record lows during the pandemic last year. However, investors seemed to be surprised at how quickly they have risen. The rising rates are not good for bonds, at least in the short term, because they cause bond prices to fall.

The Bloomberg Barclays U.S. Aggregate Bond Index has fallen over 2% year to date. However, new bond issuers will be forced to offer higher yields on bonds which would be welcomed by investors.

During periods of rising interest rates, it is important to remain diversified in the types of bonds that you own because they react differently. Maintaining shorter maturity bonds and adding international bonds that are in countries with different interest rate environments, is especially important.

If rising interest rates and inflation are being driven by higher economic growth, this can be good for stocks. As the economy grows, corporate profits should also be rising which benefits stock prices. Many companies are also able to pass through the higher cost of goods to their consumers so the profits have a better chance of keeping up with inflation.

As we have explained before, the growth side of the stock market, which includes many technology companies, was up nearly 45% in 2020 and appears to be overpriced. For our outlook in 2021, we have been more optimistic about the value side of the market, including financial companies, because their prices have not yet fully recovered from the pandemic.

Financial companies also tend to do better during rising interest rates when they can charge more for loans. So far, this prediction has been correct with financial stocks up nearly 10% and technology stocks flat for the year, looking at companies in those sectors that make up the S&P 500 index.

Rising interest rates and inflation have made investors worry for the moment about the potential impact on stocks and bonds. However, these are signs that the economy is returning more to normal and continuing to recover from the pandemic.

According to the Centers for Disease Control and Prevention, the increase in vaccine distribution could mean that the U.S. reaches herd immunity by the end of the second quarter. As this happens, we anticipate that investors will change their focus from interest rates and inflation to the growth of the economy and that the stock market (at least parts of it) will continue to benefit.