By Charley Babb
The Federal Open Market Committee (the “Fed”) increased the overnight federal funds’ interest rate from 0.25% to 1.5% on December 13th, the third rate hike in 2017. This is the first time in a long time that the Fed has lived up to their predictions at the beginning of the year. The immediate impact of this move is an increase in both the LIBOR and Prime interest rates. Those borrowers with variable rate loans based upon these indexes will see an increase in the cost of debt right away.
In a related but sometimes less obvious development, the market does not agree with the Fed’s opinion that inflation is an immediate threat. How do I know this? Because long-term interest rates have actually been declining slightly over recent months. Hence, we have a flattening yield curve, which is evidence of the market’s view on interest rates. For those of you unfamiliar with the yield curve, think of a graph with interest rates on the vertical axis and time on the horizontal axis. This measures the difference between short and long-term debt issued by the US government. A normal looking yield curve has lower interest rates in the short-term and higher interest rates in the long-term. The greater the difference in long-term rates over short-term rates, the steeper is the curve on the graph.
With the latest short-term interest rate hike by the Fed, the current yield curve is flattening out and illustrates the difference between the Fed’s outlook for the future and that of the market. So what does all of this have to do with a recession? Historically, if the yield curve flattens out and actually turns inverted (short-term rates that are higher than long-term rates), a recession has followed shortly thereafter. This has happened several times in the past 50 years – so much so that inverted yield curves have become a widely accepted market indicator for looming economic recession. Furthermore, while we have a way to go before the yield curve inverts, there is nothing readily apparent that suggests the divergent opinions of the Fed and the market will be lining back up in the near future.
Should the Fed stick to their current plan to increase rates three more times in 2018, the situation will be exacerbated and we could end up with an inverted yield curve. Outgoing Fed Chair, Janet Yellen, recently stated that “correlation is not causation” meaning that an inverted yield curve is not necessarily a harbinger of a recession. However, one thing is certain, either the Fed or the market has an incorrect view of the future at this point. Hopefully, these two opposing viewpoints will come into balance in 2018. If inflation grows over the year, the Fed is right. If not, the market is correct.
So what does all of this mean in the near-term for our clients? Those who have variable rate loans, such as construction loans, will be paying more for the privilege of borrowing that money. They may be considering utilizing option-based structures to manage their interest rate risk. Borrowers in a position to convert to long-term, fixed-rate loan products might well take advantage of the flat yield curve to lock in relatively low, longer-term borrowing costs. Based on conventional wisdom concerning the yield curve, if inflation does show up, two things can happen and neither one is particularly pleasant. Either both short and long-term interest rates will rise, making borrowing more costly; or a recession is around the corner. One way or the other, 2018 should be a very interesting year to monitor interest rates and the economy.
The Author, Charley Babb, is the Managing Director of the Denver office of Metropolitan Capital Advisors. Charley can be contacted at firstname.lastname@example.org and 720-626-6230.