The Future Path of Interest Rates

Someone I work with recently asked me if it was a good time to refinance their mortgage or if they were better off waiting for a bit. This is really two questions the first of which is, are interest rates likely to move lower, stay the same, or move higher than they are now? The second question is, do I have an economic incentive to refinance? These really are two distinct questions so I’ll address them in two different blog posts.

The first question is indeed a loaded one, packed with economic and political information and biases. The most recent rising interest rate cycle that began in December 2015 was brought to a screeching halt when the Federal Open Market Committee lowered the Fed Funds Target Rate on August 3, 2019.

Fed Funds Target Rate – Last 5 Years

That’s not totally accurate though. When the “Fed lowers interest rates” they really only directly control the Fed Funds Target Rate which isn’t even a real rate. It’s the rate at which the FOMC thinks major money center banks should lend to one another on an overnight basis, but when those banks do lend to one another, they do so at the Fed Funds Effective Rate…not the Target Rate. It’s slightly more nuanced than that, but not much.

The reality is there are lots of interest rates out there, virtually all of which are market driven. For purposes of our discussion, that is refinancing a residential mortgage, the most important rates are Treasuries and, of those, we’re really interested in the long end of the yield curve or Treasury rates with maturities from 10 years to 30 years since those are the base rates for most fixed rate mortgages. Here’s a graph of the 10 Year US Treasury over the last 5 years, the same period as the graph above.

10Y US Treasury – Last 5 Years

Is that weird? This graph shows the 10Y Treasury peaked on November 8, 2018, almost nine months before the FOMC started lowering interest rates?

It turns out that interest rates move around based on lots of things and, despite what the financial news media and President Trump seem to think, the Fed and Jay Powell only have a relatively small part to play.

Interest rates are really the yield on fixed income securities. They generally pay a rate of interest that’s contractual, but the price paid for the security determines what the yield is. One of the quirks of fixed income is that the higher the price, the lower the yield and vice versa, and just because a fixed income security was issued to pay a 5.00% rate of interest doesn’t necessarily mean that’s what the investor will receive. If investors are willing to pay more for a bond than it was worth when it was issued, the yield on the bond will drop, from 5.00% to 4.00%, perhaps. Said differently, if a bond was issued at a higher rate of interest than that available in the market today, investors will pay more for it and the yield will drop to the current market level. In this way, fixed income investors are always earning and simultaneously determining what the market rate of interest is for holding a security of a given term.

So, what would drive an investor to pay more or less for a fixed income security at one point in time versus another? Lots of factors including the current and expected health of the economy in the investor’s home country and abroad, fears or optimism about the stock market, fears or optimism about trade wars, and expectations about what the FOMC will or won’t do, just to name a few. But didn’t we already say that the Fed only has so much power? Again, it’s nuanced.

Without getting too wonky, the Federal Reserve Open Market Committee has a “dual mandate” to 1) maintain stable prices (i.e. keep inflation low and stable), and 2) to maintain full employment. Managing the direction of interest rates through the Fed Funds Target Rate is one of, if not the, primary tool used by the FOMC to effect this dual mandate. Lower rates are viewed as more “accommodative” and tend to be used to stimulate the economy. Higher rates are “tighter” or less accommodative and tend to be used to cool an overheating economy. The FOMC also buys bonds. Sometimes a lot of bonds and over the last many years they’ve bought a lot of bonds with fairly long maturities. As I noted before, if you’re willing to continue buying bonds at any price, you’ll eventually push long term interest rates lower and this is exactly what the FOMC has been doing since they first kicked off Quantitative Easing in late 2008. Yet another and, in my opinion underappreciated, tool of the FOMC is their language, both formal and informal. Don’t ever assume that anything said by a member of the Federal Open Market Committee, in a speech, in a press conference, or being interviewed anywhere at any time, is an accident.

So, after what seems like a digression, we come back to the initial question about the future path of interest rates. Normally when the FOMC raises interest rates they do so because inflation is beginning to increase in measurable and concerning ways. The higher interest rates make credit more expensive and theoretically slows capital investments, ultimately bringing inflation back in line.

That isn’t why the FOMC began raising rates in 2015 though. They began raising rates because they believed the US economy was strong enough to not be derailed by slightly higher rates and the FOMC’s ability to lower rates is their primary weapon against a slowing economy. Rates were so low in 2015 that the FOMC felt the need to raise rates in case they needed to lower them again. It seems crazy but post Great Recession was and is crazy times for monetary policy. That first rate increase in December 2015, followed by a handful of others over the following 3 and a half years or so was simply the FOMC stock piling a little dry powder.

What the FOMC did not anticipate was the stock market’s growing negative sentiment and a US President who can’t stay off Twitter and is perfectly willing to enact a full scale verbal assault on the man who arguably has the most impact on the US economy and, by design, is in an apolitical role.

S&P 500 – Last 5 Years

After peaking in September 2018 at a little over 2900, the S&P 500 cratered over the following weeks to a low of around 2350 on Christmas Eve for no real reason other than a temper tantrum. Yes, the stock market has steadily recovered since that time but President Trump has relentlessly pounded the FOMC in general and Jay Powell in particular with such quips as,

July 5, 2019 – “Our most difficult problem is not our competitors, it is the Federal Reserve.”

July 26, 2019 – 2.1% GDP is “not too bad considering we have the very heavy weight of the Federal Reserve anchor wrapped around our neck.”

Aug. 14, 2019 – “China is not our problem, though Hong Kong is not helping. Our problem is with the Fed. Raised too much & too fast. Now too slow to cut.”

I love the capital markets. I really do. But these comments from the President are just fuel for the frat boy fire and so now the FOMC finds itself in the position of lowering rates, “to sustain the expansion.” Instead of lowering rates because the economy is slowing down, they’re lowering rates to keep the party going. Most US economic indicators, including the stock market, remain pretty good and most of the news coverage about a pending recession seems way overblown if not downright absurd to me. On the other hand, if you talk about it long enough the markets will begin to believe it and add the ever-present risk of a trade war and a Twitter happy President and you have the makings of several really interesting quarters.

So, are interest rates going lower? My guess is that the FOMC cuts tomorrow (Sept. 18) and maybe one more time but will be really reluctant to do more without clear evidence that the economy is slowing down. I also think that the long end of the yield curve is way overbought, even with the pull back of the last week to 10 days, and yields may have bottomed. All of this assumes that we do not in fact have a geopolitical event like a full-blown trade war.

 Thinking of refinancing your mortgage? Now may be the best time to do so. I can’t guarantee they won’t go lower but I do think we’ll be at these levels for awhile.

In the next post I’ll take on whether or not you should refinance or how to think about the economic incentives.

Please feel free to post your comments, either in support or contradictory to what I’ve written. I’d love the feedback.

What is Your Vision?

When we begin working together, the first question I am likely to ask is, “What is your vision?” Whether you’re a church or a small business, I want to understand what it is you are trying to do and, just as importantly, why you’re trying to do it. Before we ever begin to discuss your financial situation you must be crystal clear about your vision going forward.

If you are a church, clarity of vision is required so your congregation understands how they are to engage; how they can give sacrificially of their lives in support of your vision for serving God’s people wherever you are. It will also be the litmus test for your programs and your budget. The question must always be asked, “Does this align with the vision?” If you cannot answer in the affirmative, that may be an indication that things have wandered off track.

Similarly, business owners must be absolutely clear about their vision so as to avoid trying anything and everything to make a buck. Yes, sometimes “pivots” are necessary but most of the time you will need to focus your efforts to make any real progress and as you grow, your team will need to understand the vision. Money is nice but at a certain point it stops being a motivator and your people will need to understand and share your passion for the vision just to come into work in the morning.

So, what is your vision? Think you have it? I hate to break it to you but your vision probably sounds like your mission statement and, if so, it’s too general. Take that vision and ask your self again, what is my vision? Answer it this time without using any of the same words. Got it? Describe your vision a third time, again without using any of the same words. Tired of me yet? Do it a fourth and final time. Describe your vision without using any of the phrases you used the first, second, or third time.

It’s too easy to say, “We are striving to be the best in XXX industry through technology and industry leading innovation.” That’s meaningless. “We are a place for all God’s people to come and worship.” Got it. So are the seven other churches in town. Why has God called you to minister in this place and how has He called you to do it?

I am 100% convinced God has called you to minister in that place, to build a business, to lead a church. The real question is why and how?

Not crystal clear on your vision? I’d love to talk about it with you. Contact me here.

Can We Talk About the Airlines?

I’ve had occasion to travel quite a bit recently, much of it on major commercial air carriers. These are large, multi-billion dollar companies that have mastered the logistical challenges of maintaining and flying huge fleets of aircraft, moving tens of thousands of people around the world everyday. And yet…they don’t seem to understand incentives.

I am, of course, talking about the luggage problem. With the exception of Southwest (an airline with its own problems), these carriers charge somewhere between $25 to $30 per bag for checked luggage while allowing passengers to bring one “carry on” and one “personal item” at no charge. This incents cost cautious travelers to try and carry on all of their belongings in the hope of avoiding the fees. This also means that people will try to cram more ridiculously over stuffed bags into the overhead compartments than the engineers ever intended. The result of this is people in the later boarding groups missing out on overhead compartment space, being forced to check their bags (at no cost), and the entire boarding process expanding into 40 minutes of Purgatory for everyone on board. How can this be a desirable outcome for the airlines, their staff, or the passengers?

Adding insult to injury many airlines, aware of the problems they’ve created with bags will offer a “friendly” announcement at the gate, “this is a very full flight and overhead bin space will be limited. If you’d like to check your bag all the way to your final destination, come see me at the podium and we will be happy to do so at no charge.”

Wait…what?!? You charged me $30 to check my bag before I went through security and now it’s free? Can I get a refund?

See? These people know nothing about incentives.

So what would be a better approach? One that incentivizes passengers to do what the airlines (should) want. Make it so you can check every bag you want for free and you can bring one personal item with you on the plane. Want to bring a second carry on item with you into the cabin? Perfect…it’s $50.

This would serve to make passengers really think about what and why they bring something into the cabin. You’re two piece 9′ fly rod in the Orvis case? Check it. Your bag that was too big to fit int the overhead before you overstuffed it like a Thanksgiving turkey? Checked. All of which should speed up the boarding process and make things better for everyone.

Repeat after me….align….incentives. This goes for your business or church too. If there’s something you’re trying to get people to do, just ensure the incentives are aligned. It’s much easier on everyone.