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The benchmark 10-year Treasury Note yield is near a one-year high. The upward bias of late is a reminder, albeit a mild one at the moment, that the long-anticipated run of higher interest rates has arrived. All the usual caveats apply, but we’ve probably seen the bottom in rates. This isn’t the end of the world, but it's the start of a new era.

What are the implications of higher interest rates? By some accounts, the change tempts predictions of a world that’s patently unfriendly to risky assets. No doubt there’ll be times in the years ahead when that scenario applies. Then again, it's worth remembering that risky assets weren't always immune to trouble when interest rates were generally falling in years past. In any case, we’ve lived in a world where rates have been trending lower for more than three decades, and so the prospect of reversing this move conjures all sorts of dire possibilities. It would be naïve to dismiss the dark forecasts entirely, but much depends on how quickly rates rise and under what economic conditions.

At this stage of the business cycle, higher rates still imply an improving outlook on the economy. If investors are selling Treasuries, which drives rates higher, that’s a sign of stronger demand for riskier fare—stocks, for instance. All the more so when you consider that interest rates generally remain at historically low levels despite the upward bias in the price of money lately.

At some point, higher rates will look less attractive if not threatening. No one knows exactly when that tipping point will arrive, but it seems likely that we still have a fair amount of room to run on the upside before the new era becomes uniformly burdensome for investor sentiment. For instance, the 10-year yield was routinely bumping around the 4%-to-5% range for several years ahead of the Great Recession—a period when markets were irrationally exuberant and risky assets were priced for perfection. Fast forward to the present, with the 10-year at 2.71% and macro conditions still trending positive, albeit moderately so.

Now let’s imagine that the 10-year yield is 5.0% at some point in the near future. The nice thing about bonds (Treasuries in particular) is that the current yield is a robust forecast of total return. Projecting equity returns, by contrast, is quite a bit more speculative. At the moment, it’s easy to assume that the expected return on stocks exceeds the equivalent for the 10-year Treasury (corporate bonds are another matter, thanks to their higher yields).

Deciding if Treasuries look more compelling at higher rates will remain an evolving discussion, perhaps one that will change dramatically at times, given the news du jour. The mistake, for those who allow themselves to slip down this rabbit hole, is deciding that there’s an on-off switch for bonds vs. stocks, or asset allocation choices generally, at any given moment. Rather, the rolling adjustment in ex ante risk is continual, and one that’s unlikely to move from benign to acute while you’re out to lunch. Drama plays well in our wetware, which is hard wired to look for clean and clear story lines--I was bullish yesterday, but now I'm bearish.

In fact, the hard work of managing risk is a day job, every day, and one that's fairly subtle in the short term and so it's crucial to view the outlook for rising interest rates as one more facet of your regular duties in overseeing a portfolio of asset classes. The 2.71% 10-year yield is probably going to 5.0% and higher, but not by tomorrow.

If you still need some context on what’s coming, it’s best to assume that the crowd will be alternately enthused and depressed through time as it grapples with a world of rising interest rates and other shifting states of risk conditions. In other words, nothing’s going to change for the big picture for managing asset allocation, even if the specific details in any given market are different. As those details evolve, so too should your decisions on the mix of risky assets. That said, a fair amount of the time in the months to come, higher rates will be a byproduct of stronger economic data—assuming that the economic numbers continue to lean positive. Even so, Mr. Market will suffer his usual bouts of depression as he considers the fading of cheap money.

How should we manage this strange new world of shifting perceptions and fluctuating risk profiles? The usual answer applies: diversify across the major asset classes and rebalance periodically to take advantage of price volatility. But beware: Some pundits will tell you that it’s time for a radical asset allocation strategy for the new era that awaits, and that you must change everything by Tuesday. But ask yourself one question before you go off the deep end with portfolio strategy. If most of the strategists who manage multi-asset-class portfolios couldn’t beat a passive, forecast-free asset allocation benchmark when interest rates were falling over the past decade, what makes you think they’ll do any better when rates are rising over the next 10 years?

Source: Thinking About Investing When Interest Rates Are Rising?