Last week the Federal Reserve FOMC (Federal Open Market Committee) raised its lending rate by 0.25% in a move that had been expected after weak August inflation data. The key point here is that US inflation has been above the 2% target for more than five years, severely denting the Fed’s inflation-fighting credibility.
This means inflation expectations move higher and become a self-fulfilling prophecy, especially with fuel prices remaining at record levels. What it means is that we will likely see higher inflation and rates over the next year or three.
I have written previously that higher inflation and inflation expectations result in higher long-dated bond yields, as the return needs to cover that risk of inflation.
Now we’re seeing the US 10-year trading around 5%, while the 30-year is above 5.3%. These higher yields are across all developed markets as investors are finally coming to terms with the fact that higher inflation is not temporary.
These higher yields then have further knock-on effects on other asset classes, starting with gold.
Why invest in a nonyielding (actually a negative yielding, as you have to pay to store the metal) asset that carries capital risk when you can buy essentially risk-free US debt at 5% or higher?
In a perfectly theoretical world gold would deliver a return equal to inflation. So, in a higher inflation world gold should do better. But this return is not linear or guaranteed, whereas your 10-year government bond return is guaranteed with a near-zero risk of default.
Equities can also come under pressure. Again, why buy US shares with an expected return of maybe 7%–9% when you can get US debt guaranteeing ±5%? Truthfully, it’s because you want the better return and you’re happy with the extra risk you take for that return. But the extra return above bond yields that is compensating you for the risk is lower than it has been in decades.
There would also be some investors who’d ventured into equities because they couldn’t get a decent enough yield in the traditionally lower-risk debt markets. They are likely to have looked at Reits, utilities and other high-yielding equities. But now they can return to the security of government debt for that yield — putting some pressure on equity markets.
The AI infrastructure rollout may also be under pressure, though this feels like a long shot. Higher yields on government debt should mean higher yields on corporate debt; hence, the borrowing that some AI hyperscalers are taking out now becomes more expensive, which could slow spending. But is a few extra billion on an interest bill going to slow the hyperscalers’ build-out?
Of the hyperscalers that have taken on debt (Alphabet, Microsoft, Amazon, Oracle), Oracle is the one I would worry about with its debt of almost $170bn. By comparison, Meta, Amazon and Alphabet have issued a little under $45bn of debt in the past year.
The response to higher rates is slow and uneven, but it is already happening and it will affect the return profile of some of our investments. Yields may slip lower, but so may gold and some equities.
