How can you tell when interest rates might rise, and what impact would that have on our lives? There are some simple tools you can use to answer that question and be ahead of the curve.
Interest rates have an incredible impact on our lives, from our mortgages or student loans, investments, or what we pay for different goods and services.
Low-interest rates lead to lower prices, and conversely, higher interest rates lead to increases in prices.
There are a few simple indicators that lead us in the direction of likely interest rate increases. There is no firm indicator that says this is it; interest rates will rise. Rather it is a combination of indicators that give us clues.
In today’s post, we will cover:
- The Three Forces That Shape Interest Rates
- Yield Curve and Its Impact on Interest Rates
- Consumer Price Index (CPI)
- Producer Price Index (PPI)
- An Example from The Great Recession
Three Forces That Affect Interest Rates
Three forces affect the interest rates we are charged here in the U.S. In this section, we will discuss those forces and how they impact interest rates.
I want to stress that the Fed determines interest rates, and there is no accurate indicator that will tell you conclusively that interest rates will rise or fall.
Let’s discuss these factors.
1) The Federal Reserve
The main force that the Fed uses to set interest rates is through the fed funds rate. These rates are short-term rates and are also variable.
The fed funds rate is the rate that banks charge each other to lend Fed Reserve funds overnight.
The fed funds rate is also the rate that is the benchmark for credit cards, bank loans, and mortgages.
Also, the fed funds rate is one of the main weapons against inflation the fed wields; it is also a tool to control the economy.
For more on the Federal Reserve and the fed funds rate, please go here.
The Fed uses the fed funds rate to impact the interest rates in the short-term. To get an idea of the effectiveness of that impact, they use two benchmarks to compare:
- LIBOR – the rate that banks charge each other overnight to meet their federal reserve requirements. All banks are required to keep a reserve on hand in case of a calamity; it helps ensure they are solvent in the case of a catastrophe.
LIBOR is an acronym for the London InterBank Offering Rate, which is typically set a few basis points of a point higher than the fed funds rate.
The LIBOR is used to compare overnight bank rates in the global economy, which the Fed compares to its fed funds rate. Typically, the fed fund rates are lower because it is the first-rate set, where the LIBOR is a benchmark rate that is determined by supply and demand on the funds market. The LIBOR is also calculated from five currencies and different periods from one day to one year.
The fed funds rate is a target, and the fed establishes a discount rate based on the target, which is higher than the target, which encourages banks to borrow from each other rather than pay the higher discount rate.
The Fed uses the overnight rates as a means of watching interest rates; usually, the LIBOR follows the fed funds rate rather closely, but there was a divergence during the Great Recession.
The LIBOR offers multiple different rates, for example, the current rates as of May 4, 2020, are:
One month LIBOR Rate – 0.40
Three month LIBOR Rate – 0.76
Six month LIBOR Rate – 0.86
And the current fed funds rate is 0.25 for May 4, 2020.
- Prime – The prime rate is what banks charge their best customers, and the rate is usually above the fed funds rate. But it will be a few points below the variable interest rate.
When the Fed changes the fed funds rate, the changes to interest rates can happen quite slowly. In many cases, it can take from three to 24 months for changes to occur. It just takes time for the changes to trickle down through the economy.
Banks base the prime rate on the fed funds rate, generally setting it three percentage points higher. The current prime rate is 3.25%, based on the current fed funds rate of 0.25%.
Recently, the banks lowered their prime rate to match the lower level of the fed funds rate, which the Fed lowered on March 15, 2020, from 1.25% to the current level.
Banks base most of their interest rates on the prime rate, so when the prime decreases, your interest payments might drop as well. The prime rate includes adjustable-rate loans, interest-only mortgages, and credit cards. The rates are often over prime because banks have to cover the losses they incur when loans default. Generally, the higher above the prime, the riskier the investment is perceived.
The prime rate also affects liquidity in financial markets because when lending is cheaper, it encourages more borrowing to expand or reinvest in the company.
The prime rate, LIBOR, and fed funds rate tend to move in tandem with each other. When they don’t, that indicates something is off with the economy and financial markets.
If you see any of these rates increase, that will indicate a rise in interest rates.
2) Demand for U.S. Treasury Notes and Bonds
Moving on from the short-term rate, which is set by the Fed and then impacted further by either the LIBOR or the prime rate.
Next, we will discuss the long-term rates which are impacted by Treasury investors.
Interest rates, such as mortgages, are fixed for the long-term, typically for 15-years or 30-years. The same is true for non-revolving credit such as auto loans, education, and large consumer purchases like furniture. These types of loans are typically higher than the prime rate, but lower than revolving credit such as credit cards.
Because these loans typically have one-year, three-year, five-year, and ten-year terms, they vary along the lines of the one-year, five-year, and 10-year Treasury notes. Unlike the prime rate, these rates don’t follow the fed funds rate. Instead, they follow the yields of 10-year and 30-year Treasury notes.
The Treasury department auctions these notes on the open market to the highest bidder. Bond yields respond to market demand, and if there are great demands for these notes, then yields might be lower. If the demand is lower, then the yields will need to be greater to encourage investment.
Source: St. Louis Fed
3) How the Banking Industry Affects Interest Rates
Variable interest rates changed along the lines of the fed funds rate until the housing boom of the early 2000s. As the boom accelerated, banks created new types of variable interest rate home loans. Some banks varied the rates according to a schedule. During the first year, the bank might charge 1%, the next year or two would see an increase in the rate. Most home buyers planned to sell before the interest rates increased but were stymied when the housing market started to tank in 2006.
Worse still was the interest-only loan in which borrowers only paid the interest payments, nothing was included towards the principal balance. And the absolute worst was the negative amortization loan in which the monthly loan payment was less than needed to pay the interest. Instead, the principal of the loan increased each month, which meant that eventually, the loan exceeded the value of the home.
Credit card rates are the highest because they require a lot of maintenance since they are a revolving-credit. These rates are higher than the prime and are typically the highest rates a consumer will pay.
All three of the above reasons are how interest rates affect our economy as well as give indications of the strength of the economy. Interest rates are important because they control the flow of money in the economy.
High-interest rates help curb inflation but also slow the economy. Where low-interest rates encourage growth in inflation, they help stimulate the economy.
Ok, now that we discussed the three ways the Fed influences the interest rates, let’s discuss how we can determine if rates are going to rise.
Rising Rates Indicator: Yield Curve
The first indicator that interest rates might rise is the yield curve. We discussed this briefly above, but now we will dive in a bit deeper.
The short-term interest rate that the Fed sets with the use of the fed funds rate is arguably the most important in our economy. Interest rates dramatically affect inflation, bond prices, economic growth, equity valuation, housing markets, and even gold.
The interest rate yield curve is the most important for the economy. The yield curve is the difference between short-term interest rates and long-term interest rates. In the U.S., it is most often quoted as the difference between the 10-year Treasury rates and the two-year Treasury rates. Additionally, it is one of the more reliable indicators of a coming recession.
Interest rates and bond yields are highly correlated, which is the reason for their use in predicting interest rate increases. Bonds come with different degrees of maturities, varying from one month to 30-years. When speaking of interest rates or yields, it is important to remember that there are short-term and long-term rates. Not all interest rates are correlated; they don’t always move in tandem.
For example, short-term rates might decline, while long-term rates might rise, or vice-versa. Understanding the relationship can help you predict interest rate increases, plus anticipate possible recessions.
There are three types of yield curves. They are normal, inverted, and flat.
Chart couresy of Investopedia
Normal Yield Curve – A normal yield curve starts with low yields for lower maturity bonds and then increases for bonds with higher maturity. Think of the classic chart of moving from lower to the left and climbing higher as it moves to the right.
As the curve ascends to the right, eventually it evens out as maturities plateau and flattens out the curve. The normal curve is the most common type of yield curve. Longer maturity bonds have higher yields than shorter maturity bonds. Such a curve indicates a stable economy and a normal economic cycle.
Flat-Yield Curve – A flat yield curve indicates similar yields across all maturities. You may have bumps along the road, but as you can see from the above chart, the yields and maturities are similar across the chart.
A flat curve indicates economic uncertainty. It could occur after a period of high growth, which might lead to high inflation and fears of an economic slowdown. Or it might indicate that there are fears the Fed is going to raise rates.
The uncertainty leads to investor indifference to maturities of bonds as yields flatten out across maturities.
Inverted Yield Curve – As you can see from the above yellow line, the inverted curve is opposite to the normal curve and is sloping downward. An inverted curve is where short-term interest rates exceed long-term rates, or short-term maturities have yields exceeding long-term maturities.
An inverted yield curve is abnormal but is a fantastic indicator of an economic slowdown or recession.
An example of bond yields for an inverted yield curve assumes a 2-year bond yields 3%, a five-year bond yields 2.5%, a 10-year bond yields 2%, and a 30-year bond yields 1.5%.
While the yield curve can’t be used to predict exact interest rate numbers and yields, by closely tracking its changes, it allows us, investors, to possibly anticipate, and benefit from either short- to mid-term changes in the economy.
Normal curves exist for longer durations, while an inverted yield curve is rare and may not show up for decades, although we have seen two in the 2000s. Yield curves that change to flat and steep shapes help predict changes in the interest rate environment.
Ok, let’s move on to the next predictor of interest rate increases.
Consumer Price Index As An Interest Rate Predictor
The consumer price index is a measurement of monthly U.S. prices for goods and services. It helps track inflation or rising prices and deflation or declining prices.
The index is created by the Bureau of Labor Statistics and surveys 80,000 consumer items to create the index. They represent over 87% of the population and the prices of a cross-section of goods and services the general public buys. The information is gathered from 23,000 retail and service companies.
One item to keep in mind, it does not represent the sales prices of homes, but it does include sales taxes.
The most important reason to follow the CPI is the fact that it measures inflation. As the Fed has one of its main mandates to control inflation, this metric is a great one to watch carefully. If the Fed sees that inflation is increasing, they may raise interest rates to try to slow the economy.
Ok, now on to the next indicator of an increase in interest rates.
Producer Price Index As An Indicator of Rising Interest Rates
The producer price index (PPI) is published by the Bureau of Labor Statistics, the same body that produces the consumer pride index. The producer price index is a group of indices that represents the average movement of selling prices in domestic production over time.
The main difference from the consumer price index is the producer price index measures economic activity from the standpoint of the producer, not the consumer.
Not as commonly referred to, the PPI is also a fantastic predictor of inflation or interest rate changes. The importance of this metric is that it can serve as a leading indicator of the consumer price index. When producers are faced with rising inflation, those costs are passed along to consumers, which leads to inflation of their prices.
That alone makes following the producer price index a great indicator of inflation, which we now know leads to an increase in interest rates to cool the economy.
Now that we have some idea of what to look for, let’s look at an example of conditions that lead to an increase in interest rates.
Example of Interest Rate Increases
After the latest Great Recession from 2007 to 2009, there was a long period where the Fed kept the rates artificially low to help stimulate the recovery from that terrible period.
The Fed under Janet Yellen began the process of raising the fed funds rate from 0% to 0.5%.
At that time inflation was 0.7%, and unemployment was 5.0%. Other indicators at the time:
- CPI 7.8%
- PPI 10.5%
- 2-year Treasury Notes 0.85%
- 10-year Treasury Notes 2.14%
Compared to 2007, when the recession began:
- CPI 4.1%
- PPI 3.2%
- 2-year Treasury Notes 4.93%
- 10-year Treasury Notes 4.11%
- Inflation 4.1%
- Unemployment 5%
We can see the inverting of the yield curve from the numbers in 2007, which would have indicated that interest rates were going to fall, which they indeed did in reaction to the meltdown in the economy then.
As compared to 2015, you can see a normal, rising yield curve, which indicates that interest rates might increase because you can see how much higher the other indicators are, including abnormally low inflation.
Interest rates are some of the most important drives to our economy. Rising rates have an incredible impact not only on our investment decisions, but also on our purchasing decisions and how much we might pay for any loans or credit products we own.
There are multiple indicators we can follow to get an idea of possible interest rate increases—namely the yield curve, consumer price index, and the producer price index.
The other indicator is the periodic meetings of the Federal Reserve board, which meets eight times a year. These meetings are followed very closely, and each word is closely analyzed to try to decipher the intent in regards to interest rates.
We have access to the transcripts of those meeting notes through the Fed website, but I prefer to read through the reports from other investors I respect. Much of the language is legalese, and I am not savvy with the ways of the Fed.
There is no way with any certainty to predict when interest rates are going to rise, but in the current pandemic world we occupy, they are likely to be a ways away. But using the indicators we discussed, you can get a sense of when you think those changes might occur. And if you are a bond investor, you can make changes accordingly.
That is going to wrap up our discussion for today; I want to thank you for taking the time to read this post.
As always, I hope you find something of value, and that it can help you with your investing journey.
If you have any questions, don’t hesitate at all to reach out.
Until next time.
Take care and be safe out there,