By: Lyn Alden

The TSP equity funds have partially recovered from their recent correction, but so far are still down compared to the beginning of February. The C Fund is down about 2.5%, the S Fund is down about 2%, the I Fund is down almost 4% as of late February.

The bond funds haven’t fared much better. The F Fund is down almost 1%, and the G Fund is up a fraction of a percent as usual.

Tangible Interest Rates Are Rising

The key factor that has been moving markets in the past month has been interest rates, and particularly the yield on 10-year treasuries. On days this month where the treasury yield hit recent highs, the market would go bearish and chop a few hundred points off the Dow.

The Fed has been inching up the federal funds rate for the past few years, which affects the yields on virtually all debts in the market, but it has taken a while for these changes to really affect interest rates on longer-term debt.

Here’s the long-term chart of the federal funds rate (red line) and the interest yield on 10-year treasuries (blue line). As you can see, rates hit rock bottom after a multi-decade decline, and in the past couple of years started to inch back up:

Source: Federal Reserve Bank of St. Louis (click for a bigger view)

Zooming in on the latest five years shows the current situation more clearly:

Source: Federal Reserve Bank of St. Louis (click for a bigger view)

The federal funds rate began moving up in late 2015, but because the yield on 10-year treasuries is affected by multiple variables, the correlation between the two is not perfect and it has taken a couple years for 10-year treasury yields to substantially move upward. But since the start of 2018 we’ve had a strong move upward to multi-year highs.

A big reason for recent rate moves likely has to do with the reduction of the Federal Reserve balance sheet. The Fed started increasing interest rates in 2015, but didn’t start reducing its balance sheet and undoing the affects of Quantitative Easing until late 2017, and that kept some downward pressure on treasury yields. Now that we’re in a period where rates are rising and the Fed is not buying treasuries, treasury yields intuitively should rise.

Why Rising Interest Rates Matter

The market focuses so heavily on interest rates lately for countless reasons, but here are four key ones for TSP investors to know.

Lower Stock Valuations – Historically, interest rates and stock valuations have been somewhat inversely correlated. When interest rates go very low, bond yields go low and investors are forced to invest in equities if they want decent returns, which pushes up the valuations of equities across the board. When interest rates move higher, bonds give decent interest returns and investors have less demand for equities, which can lower valuations.

Here, for example, is Yale professor Robert Shiller’s chart of the cyclically-adjusted price-to-earnings ratio of the S&P 500 compared to long-term interest rates:

Source: Professor Robert Shiller’s Online Data

There are a lot of factors that affect stock valuations, but interest rates play a big inverse role. With long-term rates starting to move up, this puts downward pressure on stock valuations, all else being equal.

Borrowing Costs – When interest rates rise, it increases the borrowing costs of consumers and corporations. For example, the average U.S. mortgage rate jumped almost 0.50% in the past 3 months, which will result in tens of thousands of dollars in extra interest costs over the course of a typical 30-year mortgage. This makes owning a home more expensive and eats into disposable income that consumers could otherwise save or spend elsewhere in the economy.

Better G Fund Returns – The performance of the G Fund closely tracks that of 10-year U.S. treasuries. Although interest rates have been rising, 10-year treasuries and the G Fund have been relatively flat in the last several years. If interest rates continue to move upward, these investments should offer higher yields (be sure to keep an eye on a White House budget proposal to slash the G Fund’s rate of return).

Federal Debt Interest – The U.S. Federal government currently spends almost $300 million per year, or 6-7% of its expenditures, on debt interest. We continue to have deficits, rising national debt, and most importantly a rising debt-to-GDP ratio, which means the interest expense will continue to rise. If interest rates on treasuries continue to rise as well, the total result can dramatically increase the total interest expense that the government pays.

Lyn Alden is a financial writer and an engineer, and holds a bachelor’s in engineering and a master’s in engineering management, with a focus on financial modeling and resource management. She specializes in analyzing and presenting financial data. Her investment work can be found on