What Is Up with These Rates?
Well, it's happened again. Short-term CD rates are higher than long-term rates. This phenomenon does not occur often, so why is it taking place in 2024?? Historically, if you give a company your money, the longer they have it, the more interest they will pay you. The financial industry calls this a standard yield curve. What we are seeing this year is an inverted yield curve. An event so rare it's only happened eight times in the last thirty years. If this phenomenon is so rare, what could be driving its emergence in 2024??
It comes down to interest rates. As many of you are aware, interest rates saw one of the fastest increases in US history last year. Many of us have been coasting along paying our 2% or 3% mortgage only to discover those same rates are now 7% or 8%. Does the rise in interest rates have anything to do with the yield curve becoming inverted? In an indirect way- yes. The Federal Reserve announced at the end of 2023 that they were planning on lowering rates in 2024 if inflation continued to cool. And this is where we finally come to our answer.
The Federal Funds Rate is the interest rate that the government sets for banks to lend to each other and other institutions. It is currently at 5.50% at the time of this writing. This is the highest the rate has been in twenty-two years. Even though the banking system in the US is very complicated and uses many terms that most of us are not familiar with, the reason that long-term rates are so low is simple- banks don't want to lose money. Period. They can offer very competitive short-term rates because they can borrow your money and pay you 5% for a 1 one-year CD, and then turn around and loan that money to someone else at 5.50% or higher. It's a low-risk proposal for them. What would happen to their balance sheets if they borrowed money at 5% from customers for a longer period?
Here lies the dilemma. The Fed has hinted a lowering rates, which creates a problem for banks. If you and I are given a 5% CD for five years, and the Federal Reserve lower rates, then the banks will be on the hook for the difference. If they are giving savers 5%, and then lending at 3% or 4%, it creates a negative yield spread that no bank wants on their books. Why would they pay out more than they are bringing in? This is what is really driving these rates. It's not the Fed increasing them, but it's the concern about when they will come down and how fast they will fall. Until banks have a better picture of rates, the economy, and inflation, the rates will continue to be inverted. So what's an investor to do?
We see clients taking two main approaches:
1. Lock in rates while you can. Many folks are looking at CDs and Treasuries in the 2-3 year range. You are still able to pick up rates in the 4-5%. If there is no need for the cash, just lock it up and ride the interest payments.
2. Take advantage of the decline. Some clients are buying mid-term bonds in anticipation of the rates dropping. If you have a bond trading at 5%, and current rates are 4%, someone may be willing to pay you a premium (or profit) for your bond. This gives clients the flexibility to hold the bond until maturity and get the interest payments, or if prices increase they can look at selling their bonds and taking the profits. The problem with this is that you will have to reinvest the cash in a lower interest-rate environment.
Plan on these inverted rates being around for a while. The eight previous inverted yield curves lasted an average of seven months. The Federal Reserve has stated they are still looking to lower rates in the spring of 2024. As long as the potential for rate declines exists, these bizarre rates may stick around.
