What are interest rates telling us?


On March 15, the Federal Open Market Committee, or the FOMC, raised its benchmark rate for the second time in the past three months. This move might not normally get your attention, but since this was only the third increase in the past nine years it is truly notable. The “Fed Funds” target rate now stands at a low range of between .75 percent and 1 percent, still at a level considered anything other than a stimulant to our domestic economy.

It should also be noted that on March 31, the shortest end of the U.S. Treasury interest rate curve, the one-month T-Bill, had a yield of .7 percent and the longest dated 30-year T-Bond was yielding 3.013 percent. A spread of 229 basis points between the one-month security and the 30-year security tells us that investors are expecting our domestic economy to continue to grow at an annual rate of somewhere around 2 percent. A “flat yield curve” also has historically forecasted that a recession is on the horizon, which isn’t that difficult to believe as we are now in our ninth year of recovery in a bull market.

The wild card in all this economic forecasting is the potential impacts coming out of the Trump administration.  “The Donald” made it a selling point of his campaign that he would repeal and replace the Affordable Care Act, reduce both personal and corporate taxes, make a $1 trillion investment in infrastructure, and spend more money on our national defense. That kind of economic stimulus could keep our economy expanding for many years to come. In fact, that kind of stimulus could push our gross domestic product growth well over 4 percent, headline inflation over the 2 percent Fed target rate and produce “wage push” inflation to levels we haven’t seen in decades.

The FOMC is well aware of these potential outcomes and is now signaling it’s planning another two or three rate increases this year. Further, in the release of the minutes of the March FOMC meeting, we were told that it might be the time now to start shrinking the Federal Reserve’s balance sheet. We just might be seeing the actual start of the unwinding of those extraordinary tactics undertaken by the Federal Reserve called “Qualitative Easing.” Remember, the FOMC had run out of ammunition in its normal monetary arsenal, interest rate decreases, and QE was a tool that allowed the Fed balance sheet to be used to buy Treasury debt, thus creating more liquidity in the financial market and leading to economic expansion. Is that a mouthful or what?

Most of you probably don’t recall this number, but on July 30,2007, near the top of the last boom, total assets held on the Federal Reserve balance sheet were $870 billion.  Between Sept. 1, 2008, and Nov. 17, 2014, the Federal Reserve grew its balance sheet to nearly $4.5 trillion in assets. The lesser-known fact is that the Fed has reinvested proceeds from those asset purchases since the end of QE in October 2014 and maintained that asset level, which stands at $4.46 trillion today. Now the process of unwinding these investments is likely to take many years, as I would imagine the “portfolio duration” would be in the neighborhood of seven to 10 years. Additionally, the Fed would need to take a staggered approach to selling such a large amount of bonds in order to not disrupt markets.

The short- and mid-term impact on the FOMC moves and the impact on interest rates will probably be muted. Certainly, adjustable-rate bank loans will begin to rise in quarter-percent increments. Credit card interest rates on unpaid balances will increase and investors in fixed-income securities, both government-backed and corporate, will see rates rise. Fixed-income bond markets increases in current issue interest rates have a negative effect on the price of the security. As rates rise, price decreases and vice versa. On interest rates offered on bank savings instruments, you will need to be patient as large banks seldom increase rates on savings as quickly as they do on loans.

We are moving into a new interest rate cycle and it will be one we haven’t seen on a prolonged basis since the early 1980s. Short-term interest rates will likely trend higher for the foreseeable future. I was taught as a young economics student in the mid-1960s that there is a “ying and yang” in every cycle, so be prepared.

Elihu Spencer is a local amateur economist with a long business history in global finance. His life work has been centered on understanding credit cycles and their impact on local economies. The information contained in this article has been obtained from sources considered reliable but the accuracy cannot be guaranteed.