The Order Arrives
Last week, we compared financial markets to the South Korean “dopamine shopping” websites where users fill up virtual carts with things they never actually buy. For months, investors had been filling their carts with expectations for Federal Reserve interest rate hikes, wondering if one would ever actually be delivered. Last Wednesday, the delivery truck finally pulled into the driveway.
Facing persistent inflation, elevated energy prices, and high government borrowing, the Federal Reserve raised its benchmark interest rate by a quarter of a percentage point. Fed officials made it clear that their goal of bringing inflation down to a steady 2% remains firm. But if investors hoped this decision would clear up the road ahead, new events quickly proved otherwise.
Trouble in the Middle East and the Energy Question
While the Fed was busy trying to cool down the economy, events halfway around the world added fresh complications. Continued and growing tension involving Iran has injected new uncertainty into the global energy market. This puts the Fed in an uncomfortable spot. Shifting tariffs and high oil prices have lingered long enough to change how families and businesses spend. The Fed simply cannot afford to ignore higher prices anymore, which means interest rates are likely to stay higher for longer.
Why a “Flat” Yield Curve Matters to Everyday Banks
In the bond market, this environment is causing what economists call a flattening yield curve. In normal times, lending money for 10 years pays a noticeably higher interest rate than lending money for three months—just as you would expect a bank CD locked up for five years to pay more than a regular checking account. When the curve “flattens,” that gap shrinks or disappears because short-term rates have risen while long-term rates remain held back by worries about future economic growth.
This shift has direct consequences for regular businesses, especially traditional banks:
• Squeezed profit margins: Traditional banks operate on a straightforward business model: they pay customers modest interest on short-term deposits and lend that money out as long-term mortgages, car loans, and business lines of credit. When short-term borrowing costs catch up to long-term loan rates, the profit margin in the middle shrinks.
• Slower borrowing: At the same time, higher overall interest rates make borrowing expensive. Home buyers step back from 7% or 8% mortgages, and companies hold off on building new facilities. With fewer loans being made and smaller profits on each loan, traditional lenders face a tougher operating climate.
The Valuation Calculus: Why Higher Rates Weigh on Everyday Stocks
Higher interest rates do not just affect borrowers—they fundamentally change how much any company is worth today. To understand why, imagine you are promised a payout of $100 five years from now. If safe government bonds pay almost 0% interest, waiting five years doesn’t cost you much, so that future $100 feels quite valuable today. But if you can earn 5% guaranteed in a Treasury bill right now, a promise of $100 five years down the road is far less attractive. You have to “discount” that future money much more heavily.
Stocks work the exact same way. When you buy a share of stock, you are buying a claim on all the profits that company will generate in the years ahead. However, the current market environment is bifurcated when it comes to how stocks are likely to be impacted.
• The AI exception: A handful of prominent tech companies tied to artificial intelligence have seen their immediate profits surge at a historic pace. Because their earnings are growing so dramatically right now, their booming business easily overcomes the headwind of higher interest rates. However, these AI-related stocks have a whole other set of risks, which we regularly write about.
• The challenge for everyone else: For the hundreds of other companies that grow at a normal, steady pace—like consumer goods makers, manufacturers, or retail chains—there is no massive profit surge to save the day. Their steady future profits simply look less appealing when investors can easily earn 5% in safe cash.
Looking Forward
For over a decade, rock-bottom interest rates lifted almost all boats across the stock market. In today’s world, the math has changed. Simply owning broad index funds may not deliver the easy momentum investors enjoyed in the past. In an environment where money has a real cost again, lasting success will depend on owning fundamentally sound businesses: companies with low debt, strong cash in the bank, and products people must buy regardless of what interest rates or oil prices do next.
Birthdays:
Actor Jason Alexander is 67, musician Ani DiFranco turns 56, and musician Bruce Springsteen is 77 today.
Christopher Gildea 610-260-2235