August 31st, 2023
Estimated Reading Time: 9 minutes

Thinking About Higher for Longer

Having grown accustomed to free and freely available capital, it is not at all clear that the low interest rate environment of the past twenty years will return.

I was hoping to write a shorter, lighter and easier-to-digest Investment Insights this month. Coming after a three-part series on Volatility, Compounding and Asset Allocation – all very long, very serious and very technical discussions – I think we could agree that both reader and writer needed the break. However, current events have conspired against our shared interest in a light, late-summer perusal. 1

Equity markets have been under pressure in August, falling almost 5% at one point, from a subtle shift in market sentiment worth commenting on. Throughout the Federal Reserve’s rate-hiking campaign, investor attention has been focused first on how high interest rates would need to go to control inflation and then on how quickly thereafter, and how far, interest rates would fall.

The first question has been answered largely as expected. The Central Bank hiked interest rates for what could be the final time on July 26th. The second and third questions, however, remain unanswered. While investors have long hoped “soon” and “far” would prove correct, in recent weeks market sentiment has shifted toward “maybe not as soon” and “maybe not as far” as previously thought. Though subtle, this shift is important enough to the purposes of protecting and building wealth to abandon existing plans in favor of a timely discussion. 2

First, some historical context. When the Fed started raising interest rates last year, it ended a twenty-year period of expansionary monetary policy that featured 0% nominal interest rates, negative real interest rates and $9 trillion of Quantitative Easing. 3 The chart below shows how historically anomalous this period was. The key takeaway is that for two decades the economy had grown accustomed to free and freely available capital and investors had become conditioned to Fed support for high asset prices.

Given recent and prolonged experience, it is certainly understandable that investors would expect interest rates to return to very low levels after the current bout of inflation is squashed. 4 However, investors are now opening their minds to the possibility that maybe interest rates won’t be going back down for a while and won’t be going down as far once they do. This shift, to “higher for longer,” has far-reaching implications.

Why might this shift be happening? Among many factors, long-term interest rates reflect expectations for future inflation and economic growth. Strong economic growth this year, despite rising interest rates and stubborn inflation, has raised concern that higher long-term rates could be necessary. For the current quarter, the Federal Reserve Bank of Atlanta’s GDPNow estimate is 5.8%. 5 If correct, this would be the strongest such figure since the third quarter of 2003 (excepting the post-pandemic reopening period), despite interest rates at a supposedly restrictive level.

This dichotomy is spurring some economists and investors to update their estimate of something called r* (pronounced “R-star”). r*, which can only be estimated, not observed, is the hypothetical neutral real rate of interest that neither slows nor accelerates the economy. Over the last two decades, estimates of r* had generally fallen due to globalization, geopolitical stability and demographic tailwinds. Now, with strong economic growth despite restrictive monetary policy, deglobalization, geopolitical instability and demographic headwinds, some Fed officials are beginning to speculate that the current consensus for r* is too low.

There are more practical factors driving this shift as well. When the Fed stopped buying treasury bonds in March 2022, one very large, price insensitive buyer left the market (less demand). This happened as rising government deficits were driving the issuance of large amounts of treasury bonds (more supply). With less demand and more supply, economics dictates that treasury bond prices had to fall. As prices fell, yields (interest rates) increased. 6

Why do long-term interest rates matter? The short answer is that long-term interest rates affect just about everything in the world of finance, which then in turn affects a wide range of real-world behavior. These changes can have profound and lasting implications, both mathematical and psychological.

The mathematical implications are straightforward. Higher interest rates mean that the present value of future cash flows is less than it was before. 7 Conversely, current cash flows are less affected and become relatively more valuable. At the margin, this should shift investor preferences from speculative, often fast growing, but money losing businesses toward profitable businesses that are currently generating cash flow, reducing the price of the former and increasing the price of the latter.

TINA dies as well. TINA, fortunately not a real person, is an acronym for “there is no alternative” used during the extended period of low interest rates to describe investors’ reluctant purchase of equities to achieve a required rate of return when they would otherwise prefer to purchase bonds if interest rates were higher. 8 With rates higher now, some investors will gladly sell equities and go back to bonds to achieve their required rate of return, putting downward pressure on equity prices.

More broadly, equity valuations should decline. As the yield on treasury bonds rises, a return considered to be risk-free, the earnings yield on equities, which reflects a risk premium over the risk-free yield, should rise as well. As the earnings yield on equities rises, equity prices must fall (all else equal). 9

In the real world, higher interest rates will mean a higher cost of capital for businesses, which will translate into a higher required rate of return on investments. All else equal, this should slow business investment.10

Higher interest rates will also reduce corporate earnings as interest expense increases. Interest expense will increase as floating rate debt reprices higher and as outstanding debt is refinanced at the now-higher prevailing interest rate.

Consumers’ cost to borrow money will increase as well. This will make any type of large purchase that is typically financed, cars and homes being prime examples, more expensive as well as make it more costly to carry a revolving credit (i.e. credit card) balance. Anyone in the unenviable position of trying to buy a home knows this well, with mortgage rates recently hitting a 20-year high.

The psychological implications are more abstract, but no less real. Higher long-term interest rates can have a negative impact on risk taking, above and beyond simply making it more expensive to do so. The “animal spirits” in the market that you often hear about tend to quiet or go silent altogether during such times. Perhaps safety is simply seen as more rewarding for the moment. If not explicitly caused by higher long-term rates, the phenomenon is certainly correlated.

Falling asset prices, as mathematically outlined above, can sometimes cause the “wealth effect” to wane or reverse. The wealth effect suggests that people tend to spend more money when rising asset prices make them feel wealthier. 11 The reverse holds true as well. When asset prices fall, people tend to spend less money. This does create the risk of a negative feedback loop emerging, whereby falling asset prices due to psychological reasons cause spending to slow, which in turn causes asset prices to fall further still, this time due to fundamental reasons, which then cause spending to slow further still and so on and so on.

We haven’t seen long-term interest rates this high in fifteen years. Since then, we have grown accustomed to low interest rates as normal. While it is natural to extrapolate the future from the recent past, it is not at all clear that we will go back to the low interest rate environment of the past twenty years.

Whatever the new normal, adjusting to it will take time and surprises will emerge along the way. Silicon Valley Bank, for example, was decidedly unprepared for a higher interest rate environment and failed because of it. Similarly, though lesser well known, many U.K. pension funds suffered a liquidity crisis in late 2022 as interest rates increased, only to eventually be bailed out by the Bank of England.

These two examples show the danger of optimizing for a particular environment rather than remaining flexible enough to survive in any environment. This is paralleled in biology. The evolutionary process is described as “survival of the fittest.” Read those four words carefully. It does not say survival of the “best.” As you think about protecting and building wealth over time, your goal should not be to be the best in a particular environment (or period of time as it applies to investing), but rather to survive well enough over time in any type of environment to allow the benefits of long-term compounding to accrue.

Thoughts? I would love to hear them. Email me at

Written By Keith R. Schicker, CFA

Interested in Reading More?

Sign up for our bi-weekly newsletter to receive educational content, investment insights, and financial planning tips emailed directly to you.

Zuckerman Investment Group, LLC (“ZIG”) is registered with the United States Securities and Exchange Commission (“SEC”) as an investment adviser. Such registration with the SEC does not imply any certain level of skill or training. It also does not imply that the Firm is recommended or approved by the United States government or any regulatory agency. The information contained in this email has not been filed with, reviewed by or approved by the SEC or any other United States regulatory or self-regulatory authority.

The information in this e-newsletter for general guidance only, and does not constitute the provision of legal advice, tax advice, accounting services, investment advice, or professional consulting of any kind. The information provided herein should not be used as a substitute for consultation with professional tax, accounting, legal, or other competent advisers. Before making any decision or taking any action, you should consult a professional adviser who has been provided with all pertinent facts relevant to your particular situation. Tax articles in this e-newsletter are not intended to be used, and cannot be used by any taxpayer, for the purpose of avoiding accuracy-related penalties that may be imposed on the taxpayer. The information is provided “as is,” with no assurance or guarantee of completeness, accuracy, or timeliness of the information, and without warranty of any kind, express or implied, including, but not limited to, warranties of performance, merchantability, and fitness for a particular purpose.

Zuckerman Investment Group, LLC may only transact business or render personalized investment advice in those states and international jurisdictions where it is registered, has notice filed, or is otherwise excluded or exempted from registration requirements. This is for information distribution only and should not be construed as an offer to buy or sell securities or to offer investment advice. Please refer to Zuckerman Investment Group, LLC’s ADV Part 2 (brochure) and Form CRS for additional information.

We have no responsibility for any information or policies of any other websites that may be accessible from this email via hyperlink. Zuckerman Investment Group does not endorse, sponsor, or promote any products or services offered by any website that may be linked to this email. If you access any other website through this email, you do so at your own risk. Parties may not reproduce this email in any form, nor reference it in any publication, without the express written consent of Zuckerman Investment Group, LLC.

  1. I was planning to write about the Vinfast Auto Ltd. initial public offering. Vinfast is a Vietnam-based electric vehicle manufacturer with a market capitalization approaching $200 billion (more than General Motors, Ford and Stellantis, the parent company of what used to be Chrysler, combined) despite having sold only 18,700 electric vehicles total (as of June 30, 2023) since December 2021. Alas, perhaps another day.

  2. A timely discussion that I will try to keep as short, light and easy-to-digest as possible.

  3. The nominal interest rate is the stated interest rate. The real interest rate is the stated interest rate less inflation. For instance, the current Fed Funds Rate is 5.5% and the current inflation rate is 3.2%. So, the nominal interest rate is 5.5% and the real interest rate is 2.3%

  4. Recency bias, sometimes also called extrapolation bias, is the tendency to overemphasize the importance of recent experiences or the latest information we possess when estimating future events.

  5. GDPNow is a running estimate of real GDP growth based on available economic data for the current measured quarter. The first estimate of official GDP from the Bureau of Economic Analysis is not released until October 26th.

  6. Bond prices and bond yields move inversely to each other. As bond prices fall, yields rise. As bond prices rise, yields fall.

  7. Converting future cash flows to a present value is called discounting. Discounting is the opposite of compounding, which I discussed in a recent Investment Insights. Just as compounding a small amount today at a high rate turns it into a large amount in the future, discounting a future amount at a high rate turns it into a small amount today.

  8. Pension funds were particularly hurt by this dynamic, forced to choose between taking incremental risk to achieve their required rate of return or maintaining their risk standards and simply accepting a lower rate of return.

  9. Earnings yield is simply earnings / price. If a stock earned $10 per share and was priced $100, the earnings yield would be 10% ($10 / $100). If the risk-free rate was 2%, the stock would have a risk premium of 8% (10% – 2%). If the risk-free rate were to increase to 5% and the risk premium were constant, the stock’s earnings yield would increase to 13% (5% + 8%) and its price would fall to $76.92 ($10 / 13%)

  10. In theory, businesses will only invest when the expected return on the investment exceeds the cost of capital for the business. If an investment had a 10% return, the business would make the investment if its cost of capital were 8%, creating a profit of 2%, but would not make the investment if its cost of capital were 11%.

  11. Though by no means definitive, there is academic research supporting the existence of the wealth effect. Some believe that the Fed’s efforts to support higher asset prices over the past two decades were an attempt to drive faster economic growth via the wealth effect.