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Will Interest Rates Ever Go Higher?

Interest Rates - Federal Reserve

For some time now, anyone in need of borrowed capital has been floating in a pool of cheap money offered at historically low interest rates. However, with lenders moving from extraordinarily loose underwriting standards to much more stringent ones, strict lines in the sand have been drawn in terms of who is actually eligible to take advantage of these low interest rates. The proverbial pendulum has swung way to the other side of where it was prior to the financial crisis.

US Treasury Interest Rates

As lenders put borrower attributes under the microscope, the low interest rate environment has hurt credit spreads, impacting the ability of banks and other financiers to sustainably grow business. Further, low interest rates have virtually wiped out the thought of savings accounts and CDs as legitimate investment vehicles. Not too long ago, depositors could find interest rates 5% on money market accounts. Today, you probably have to lock in CD money for 5 years to get a whole two percent.

Since we exited the financial crisis seven years ago, various doomsayers and bond bears have been predicting that a credit or bond bubble could bring the global macroeconomy to its knees. So far, we don’t have any evidence that will occur, although  clearly there seem to be major stumbling blocks inhibiting the path to global sustainable growth.

In general terms, rising interest rates may be indicative of growth or higher than historically normal inflationary pressures, while lower interest rates may be indicative of slack growth, deflation, or need for growth stimulation. The need for low rates in the aftermath of the financial crisis was obvious. Since then, the Fed has started — and stopped — various rounds of QE (quantitative easing). Today, there is clear desire on the Fed’s part to raise rates, but equity volatility, a drowning middle class, and a fragile housing market, amongst other issues, is putting a hamper on their ability to do so.

The last thing the Fed wants to do at this point is quickly raise interest rates, watch a recession develop, then start cutting again.

Understand Bond Market Separation

While Fed action governs overnight lending rates between depository institutions, Fed Funds movement should not be confused with what occurs in the bond market. Treasuries, corporates, and municipals all trade in an open market and are generally priced in accordance with supply/demand dynamics. Fed funds and bond yields may in many cases run in parallel motion, but that doesn’t have to be the case.

During 2013 after Ben Bernanke announced that Fed intent was to taper its stimulative bond buying, investors reacted negatively, and pushed the yield on the 10-year Treasury from below 1.75% all the way up to 3% by the end of the year. In December, the Fed raised interest rates (25bp) for the first time in nearly a decade, but the 10-year Treasury yield dropped a half point (.50%) over the next six weeks.

Types of Yield Curves

The look of the bond yield curve will vary depending on what investors anticipate, economically speaking.

A normal yield curve is when rates increase in orderly fashion relative to their duration. This is what we see a majority of the time.

An inverted yield curve is said to be predictive of recessions. In this case, short yields are higher than long yields.

A flat yield curve, when short- and long-yields trade at a similar rate is generally indicative of uncertainty on the part of investors.

Conclusion

It would be a fallacy of logic to assume that the Fed Funds rate will ultimately move meaningfully higher just because it’s been low for so long, although this is what some investors seem to think. The reality of the matter is that conditions must exist in the economy that enable, and allow, the Fed to increase rates without jeopardizing current financial market health. It’s possible that we might experience ZIRP for another decade, despite what bond bears might want you to believe.

This is obviously a very subjective call on the part of central bankers that takes into account a wide swath of macro- and micro-economic variables. My personal view is that a series of rate hikes would bode poorly for the fragile housing recovery we seem to be seeing, and costly to the middle-class. Thus, if you are holding cash anticipating some rapid rise in risk-free yields, you might be in for a long wait.

All trading carries risk. Views expressed are those of the writers only. Past performance is no guarantee of future results. The opinions expressed in this Site do not constitute investment advice and independent financial advice should be sought where appropriate. This website is free for you to use but we may receive commission from the companies we feature on this site.
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Adam Aloisi has over two decades of experience investing in equities, bonds, and real estate. He has worked as an analyst/journalist with SageOnline Inc., Multex.com, and Reuters and has been a contributor to SeekingAlpha for better than two years. He resides in Pennsylvania with his wife and two children. In his free time you may find him discussing politics, playing golf, browsing antique shops, or traveling.

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