Let’s Talk Interest Rates

Who sets interest rates?

When the media refers to interest rates, they are almost always referring to the nominal rate, known as the federal funds target rate, which is set by the governors of the Federal Reserve. The federal funds rate is the interest rate at which banks and credit unions lend excess (surplus) reserve balances to other depository institutions on an overnight and uncollateralized basis. The Federal Open Market Committee meets about eight times a year wherein they determine the direction of interest rates and set the rate. When the committee raises rates, it is often referred to as “tightening”. When they lower rates it is referred to as “easing”. Both of these actions can have a profound effect on the economy and the consumer.

What is the yield curve and why is it important?

The yield curve is an illustration, depicted as a graph, which plots the interest rates of bonds (with the same credit quality) over a specific period of time. A period of 3 months to 30 years is typical of a yield curve illustration. A healthy yield curve slopes upward because fixed income investors want to be compensated for the additional risk of investing in longer term debt.

Recently, the yield curve has been flattening. This means that the difference between the interest rates paid on short term bonds and the interest rates paid on long term bonds has been decreasing. There are many things that can cause this. The Federal Reserve raising interest rates can cause the yield curve to flatten. Anticipation of lower inflation and or slower economic growth can also cause a flattening of the yield curve.

If the yield curve flattens to the point where short term rates are actually higher than long term rates, this is referred to as an inversion or an “inverted yield curve”. An inverted yield curve has preceded all nine of the recessions in the United States since 1955. Although an inverted yield curve is certainly not a guarantee of a future recession, it has been a pretty consistent and accurate predictor over the past 60 years.

How do interest rates affect the different asset classes?

Let’s start with cash. Higher interest rates will find their way into cash alternatives like savings accounts, money market rates and rates on certificates of deposit. For the risk averse, this could be a positive. But that’s pretty much where the benefits end.

As we have discussed in previous issues of Cody Living, bonds, on the other hand, have an “inverse” relationship with interest rates. Existing bonds in the marketplace will fall in value as new bonds come onto the market with higher coupon (interest) rates. As far as equities (stocks) go, the first stocks to feel the pinch of higher interest rates are usually high dividend paying stocks like utilities. This is, in part, because their dividend yield is competing with the perceived safer alternative of treasury bonds and AAA rated corporate bonds. As the money supply tightens and the cost of capital rises, business expansion will contract resulting in a slowing economy and falling GDP.

With respect to real estate, higher interest rates will raise the cost for borrowers. This often results in an increase in inventory and a reduction in buyers which causes falling prices. The simple law of supply and demand oversees this process.

In my two decades of experience working in the investment management business, I have seen these interest rate cycles play themselves out several times. I believe the biggest risk, at present, is that that the federal reserve overshoots and unnecessarily tightens (raises rates) too much, too soon, as I have seen them do in past. Should this occur, it is possible that the Fed actually causes an inversion of the curve and thereby pushes us into a recession. The biggest risk to our economy is deflation right now, not inflation. Stay tuned. We could see significant changes to the Federal Reserve over the next few months. President Trump has four vacancies to fill.

Some of these financial subjects and concepts can get complicated because there are so many other factors involved. When I sit with clients, I like to literally draw them a picture to make it easier to understand. The white marker board in our office gets a great deal of use. It is also difficult to go into great detail in an article of 1000 words or less. If you would like additional information, or if we can help in any way, please don’t hesitate to call or stop by our Cody office.