Long-term interest rates are rising. Could they trigger a recession – or are they a sign of strength for the US economy?

For all the fear about higher interest rates, we shouldn’t forget that they can be a sign of economic strength – and we believe they largely are. This may sound controversial, but we’ve been here before. In 2022, significantly higher short-term interest rates led to calls of an “inevitable” recession, but no recession has yet occurred. The US economy was so strong that it withstood the rapid rate hikes.

Now in 2023, as short-term rates near their peak, long-term rates have continued to rise sharply, reaching 4.89% in the last few days. Is this a sign of stress that is finally triggering the long-feared recession? Or is it another sign of strength that forces a new balancing act in monetary policy but allows US economic expansion to continue? The answer can be found by looking at the dark narratives and examining the mechanisms by which strength leads to higher ratings.

Popular narratives that failed to catch on

As interest rates have risen, headlines about an impending US debt crisis – and even a possible default – continue to accumulate. But the idea that soaring debt and growing deficits have finally caught up with the United States is unfounded. It is true that debt is rising rapidly and that it is unwise to have large deficits. However, the narrative of a sovereign debt crisis is not compatible with sustained and significant currency strength. Not only does the dollar remain exceptionally strong, it has also risen sharply as interest rates rise. One day this could be the threat. Today is not that day.

A softer, less grim version of this narrative is that the “bond vigilantes” have returned – bond traders who respond to irresponsible financial policies by selling debt and driving up yields. Although vigilantes are stirring today, they no longer have the power that forced President Jimmy Carter’s budget rollback in 1980.

It was a broken inflation regime that gave power to bond watchdogs, particularly unanchored inflation expectations that underlay the ugly 1970s. Today, inflation expectations are entrenched, weakening the vigilante’s offspring. Instead of facing a bond market veto, policymakers are pushing for higher interest rates—and getting what they want.

Of course, the 1970s have been another popular narrative over the past two years that hasn’t panned out. Instead of breaking the inflation regime, the Fed broke the inflation fever. After peaking at a frightening 9.1% in June 2022, it has fallen to 3.7% in August. And no measures of inflation expectations suggest an unhealthy upward breakout that would explain rising bond yields.

While we don’t think it’s primarily about debt and deficits (or bond supply), higher interest rates could well reflect a different kind of risk premium. They could be a signal that the insurance value of long-term bonds has fallen. Long-term debt has long been a reliable hedge against risk: when stock prices fell, bonds rose (i.e. yields fell). Now that the Fed has raised interest rates to slow the economy, this hedge, known in the trade as negative bond-stock correlation, hasn’t worked. Portfolio managers who previously paid high prices for bonds because of their insurance value are now less likely to do so, driving up returns.

Higher interest rates bring risks – but remain a sign of strength

Just as portfolio managers must prepare for the consequences of higher interest rates, companies must also prepare for them. Higher interest rates are often viewed only from the perspective of risk, such as a cascade of corporate failures or further failures in the banking system. These fears should not be dismissed lightly. The rise in corporate bankruptcies, from Bed Bath and Beyond to Party City, is real (albeit from very low levels). Likewise, the collapse of the SVB at the beginning of 2023 showed that the financial system is vulnerable to changes in the interest rate environment.

However, we must remember that financial stress and corporate failure are precisely the channels of monetary policy. A reduced loan slows growth. And bankruptcies lead to a reallocation of resources – especially labor – toward more productive uses. While financial fragility is not the goal, persistent bankruptcies can be seen as part of the goal of tightening monetary policy. Paul Volcker was once asked how monetary policy helped reduce inflation “by causing bankruptcies,” he replied.

The real and present microeconomic stress and pain should not obscure the fact that high long-term interest rates are a result – and a sign – of macroeconomic strength.

The first driver of high long-term interest rates is cyclical strength. Markets had incorrectly assumed a high probability of a recession in 2023 and with it the possibility that interest rates would fall quickly. As the previously unpopular soft landing narrative gained traction, the prospect of significantly lower short-term interest rates dimmed. And since long-term interest rates reflect expectations of short-term interest rates over their horizon (combined with a term premium), this also meant higher long-term interest rates.

The second driver reflects structural strength. Despite the significant decline in inflation, it is likely to remain above the 2% target in the coming years. This suggests a cautious Fed that will only gradually adjust its policy back towards a neutral interest rate. As a result, short-term interest rates remain higher for longer. Policymakers have been saying this for some time, but markets are starting to believe them.

Thirdly, the perception of the “neutral” interest rate is also trending upwards. Even if inflation returns to target and policymakers easily lower the key interest rate to neutral, that rate could be higher than recently estimated. This neutral interest rate (also known as R-Star in technical jargon) is unknown and fluctuates, but it has an influence on long-term interest rates.

What’s next – and why

Although the shifts in short-term and long-term interest rates reflect different dynamics, both speak to macroeconomic strength that policymakers want to contain. Raising the key interest rate has proven to be effective (inflation has fallen), but less effective than most people thought (there has been no recession). Now the rise in long-term interest rates, over which the Fed has less influence, is the next balancing act.

The economy has a good chance of muddling through. Growth will prove modest but may remain robust. Inflation will continue to moderate, but not completely. Monetary policy will ultimately aim for normalization, albeit very cautiously. This suggests that long-term interest rates will remain high and moderate only slightly in the coming years.

On the other hand, if the economy proves to be too strong, the dampening of inflation is too moderate or even accelerates, and today’s high interest rates do not represent enough of a headwind for the strong economy, interest rates will have to rise even further. But even that would not necessarily be a sign of an economic crisis, but rather reflects the ongoing challenges of containing a strong economy to prevent overheating.

Meanwhile, a real recession could strike at any time, undermining growth and inflation and prompting policymakers to adopt faster and deeper austerity measures than expected. This would probably reduce interest rates significantly. The extent to which they would fall depends on how convincingly inflation continues to decline and how severe the downturn is.

However, none of these paths involve a debt crisis, structural inflation or a credit crisis. And while both are possible, the rise in long-term interest rates has not moved them to the middle of the risk distribution.

Philipp Carlsson-Szlezak is a managing director and partner in BCG’s New York office and the firm’s global chief economist. Paul Swartz is director and senior economist at the BCG Henderson Institute in New York.

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