Quarterly Commentary – July 2019
Why are interest rates so important and what is this Federal Funds Rate that is so frequently discussed?
Interest rates are important because they set the cost to borrow money for purchase of major items such as homes and cars, education, business development, credit cards and simply put impacts most every financial decision that is made. Should I buy? How much can I afford? Should I borrow? If I borrow how much will it cost me to pay back? Interest rates impact all of these questions and of course play the biggest role if one is to borrow to engage in any of these transactions. However, interest rates impact far more than borrowing.
In making investments one should always ask themselves what is their objective and what is required of this particular investment. For example, if “risk” or absence of fear of getting your money back is the most primary concern one may look to invest in a US Treasury Bond. In theory (and we believe in practice) an investment in US government issued bonds is still one of the safest if not the safest investment in the World. If I purchase a 10 Year US Treasury Bond the transaction is in effect a loan to the US government for the next ten years. Interest rates for US Treasury Bonds are determined by buyers/sellers in the open market and as of Friday June 28, 2019 the yield or interest payable on a 10 Year US Treasury Bond was 2.007%. So, the deal is this, you lend money to the US government and every year for the next ten years you will receive 2.007% interest on the money you lent and at the end of 10 years the government will pay you back. If I had purchased a $100,000 ten-year Treasury this past Friday, I would receive $2,000.07 in interest every year for the next 10 years and on June 28, 2029 I will get my $100,000 back. A very simple transaction. If a 2% rate of return is enough to meet your needs a US Treasury is a perfect fit and you do not need to look any further. However, for most this is not enough so other investments come in to play.
This is one of the first keys as to why interest rates are so important. Let’s say the 10 Year US Treasury Bond was paying an interest rate of 15.84%? In fact, that was the rate paid on 10 Year US Treasury Bonds issued on September 30, 1981. In that case the “riskless” transaction would pay you 15% so to do something different would have to have the potential of even better returns or there could be other motivations. For example, in September 1981 the Inflation Rate was 11% and therefore in effect the net interest rate was 4.84% (interest rate minus the rate of inflation). In comparison the Dow Jones Industrial Average on that same day stood at 849.98. Since 1962 the average interest paid on the 10 Year Treasury has been 6.15%.
How about the Federal Funds Rate and what is that? This rate is the amount charged by banks to lend to each other, overnight, to meet the demands of the next banking day. Think of it this way at the end of each day there a huge amount of financial transactions that need to be cleared and settled. Checks have been written and one bank owes money to another or money needs to be sent out to make payments to cover the checks written by customers of each bank. In doing all of this reconciliation one bank might fall below the levels of available cash or Reserve Requirement as has been set by the Federal Government. So, one bank may borrow from another but to protect the system the Federal Government places a limit that these loans can only be made from those amount the lending bank has over their reserve requirement. In other words, if a bank does not have enough liquidity of its own it cannot engage in these loans. Money held by banks to meet the Federal Reserve Requirement earns no interest. The government through the Federal Open Markets Committee (Fed) sets a range of rates that can be charged on these overnight loans. This is called the Federal Funds Rate and becomes the foundation of interest rates in general. As of now, June 28, 2019 this rate is 2.38% (within the range set by the Fed).
So again, Why is this so important?
Here is why. Low interest rates make it easier to borrow for all of the reasons enumerated above AND provides less competition for other investments. Low interest rates create more borrowing which in turn means more home/car buying, more development loans, more student loans, on an on. Low interest rates mean people are willing to accept more volatility in their investments to seek a higher rate of return. Again, if 2% floats your boat then you need to look no further than 10 Year US Treasury Bonds but for most that is not a reasonable option.
Here is a look at what interest rates have done over the past 12 months.
|Date||10 Year US Treasury||Federal Funds Rate|
|June 30, 2018||2.85%||1.91%|
|September 30, 2018||3.05%||2.18%|
|December 31, 2018||2.69%||2.40%|
|March 31, 2019||2.41%||2.43%|
|June 28, 2019||2.01%||2.38%|
Investors set the 10-year rate through buying/selling activity and the Open Market Committee sets the Federal Funds Rate. Markets have lowered the 10-year rate 34% since September 30, 2018 and the Fed has increased interest rates by almost 10%. Think there will be a rate cut after the next Open Markets Committee meeting on July 30-31? The feeling on Wall Street is almost a 100% certainty. If this happens there may be very little stock market impact due to the high anticipation of a rate cut. However, if the yield on the 10 Year Treasury remains low and the Committee does not lower rates there may be extreme stock market disappointment and a resulting (we believe temporary) reduction in stock prices. Stay tuned for 11:15 AM (Pacific time) on July 31 for the big announcement.
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