What's Happening with Interest Rates

Jul 31, 2022

Author’s Note: I hope everyone is having a nice summer. I’ve been enjoying some family time lately and my wife and I are going through a kitchen renovation project that has been highly disruptive but we are just about at the finish line. I’m pleased to report we remain happily married. As I think a lot of people are experiencing the dog days of summer in their own ways, I’ve just got a quick article today where I thought I would address the question that I am being asked multiple times a day in my work as a lender: what’s happening with interest rates. Check back next week for more content and, as always, thanks for reading The Sunday Morning Post.

adult white and black border collie jumps to pool — Photo by Murilo Viviani on Unsplash

What’s Happening with Interest Rates

Some interesting things are happening in the interest rate market, which I’ll delve into. But first, a quick review of why interest rates have been going up. For most of the pandemic, the Federal Reserve held interest rates at artificially low levels. Why? To spur economic activity. When rates are low, the cost of borrowing is less, which means more people can afford more things: homes, cars, RVs, business expansions…you name it. When something is purchased like a home or a vehicle, there is an economic ripple through the economy, so the economy typically does well during periods of low interest rates because the low rates stimulate a lot of economic activity.

So why raise rates at all? Why not just let the economy run hot? Well, when rates are low for too long, it can not only create bubbles in certain sectors of the economy that eventually might pop and make people worse off, but inflation becomes a reality as prices rise amid roaring demand. That is pretty much exactly what has happened. Inflation is like an extra tax on us all, and the particularly troubling thing of late is that the prices of things like food, gas, housing, and utilities are what have risen the most (i.e. the things that regular Americans have to spend money on). So in order to tame inflation, the Federal Reserve is now jacking up interest rates in an effort to basically cool things down even if it means tipping the U.S. economic right into a recession.

So, what is happening with interest rates of late? Let’s take a look at the broad categories:

Commercial Rates

Most banks pin commercial interest rates to something like Prime Rate or the Secured Overnight Financing Rate (SOFR). My bank typically uses Prime Rate. A pretty standard commercial rate is typically 100-150 basis points (1.00-1.50%, in layman’s terms), above Prime Rate. Prime Rate for most of the pandemic was 3.25%, so our bank, like many others I’m sure, did a lot of commercial loans with a fixed rate of 4.25-4.75% over the past couple of years with that rate being locked in for the first five years of a term (commercial loans typically fix for only 3-5 years).

The Fed lowered Prime Rate from 4.25% to 3.25% in March 2020 once it became clear that the pandemic was going to have a major economic impact. It stayed at 3.25% until March 2022, when the Fed raised Prime Rate to 3.50%. In May they raised it again to 4.00%, notable in that they dispensed with the usual 0.25% increase to bump it up by 0.50%. In June they increased it to 4.75%, notable yet further in that the bump was by a fairly unprecedented 0.75%. And then just earlier this week on July 28th, the Fed increased Prime Rate by yet another 0.75% to 5.50%. Prime Rate has never increased so much, so fast as this.

The effect on commercial rates has been significant with rates for new commercial loans typically being in the 6.00-6.50% range. Economists collectively estimate that Prime Rate is likely to increase by another 0.75% to 1.00%, which would take the rate to 6.25-6.50% by the end of the year, which would put commercial loan rates in the 7.00%+ range. I do not speak for anyone other than myself in saying this, but these rate increases will undoubtedly have an effect on the amount of commercial borrowing that takes place, which means fewer businesses will expand, fewer commercial transactions will take place, and less commercial activity will occur, which, of course, is the whole point of the Federal Reserve increasing rates the way they have been.

Residential Rates

A funny thing happened on the residential side of the ledger this week, however: interest rates actually came down a bit. After the 30-year fixed mortgage rate peaked nationwide at an average rate of nearly 6.00% in June, the 30-year rate is now down to 5.30% as of the end of this past week. The chart below shows some softening in mortgage rates, welcome relief to anyone looking to finance a home acquisition in the next month or so as the difference between 6.00% and 5.30% can make a difference of tens of thousands of dollars over the life of a loan.

Chart of the average 30-year fixed mortgage rate since January 2022. Source: FRED/St. Louis Fed

Why are residential mortgage rates coming down? The pricing of residential rates is complicated and, quite honestly, beyond my ability to fully understand and explain, but I will try to offer it in a nutshell: residential home loans are typically sold by banks to other financial institutions that collateralize them as mortgage-backed investments. This week’s GDP numbers were particularly weak and pointed towards a recession. With that in mind, investors are flocking to safe investments and, indeed, mortgage-backed securities are thought of as safe investments (most types of them, anyway). Right now there is enough investor demand for lower-interest rate mortgages for banks to justify lowering their fixed-rate mortgage interest rates from the high 5.00’s and low 6.00’s to the low-to-mid 5.00’s.

For a more comprehensive and detailed overview of why home mortgage rates dropped this week (and with reference to the GDP numbers), check out this post from Mortgage News Daily, which offers a better and more full explanation.

Savings Rates

As of yet, I have not seen much evidence yet that savings rates are increasing much. This is not great news for conservative savers (i.e. people who save funds in CDs, savings, and money market accounts). Rates just remain stubbornly low, especially when considering inflation, which erodes the purchasing power of these dollars further. Bond rates and U.S. Treasury Bills are also not increasing in any sort of meaningful way, with the yield on the 10-year Treasury Bill holding steady around 2.65%. That means if you want to lend the United States government your money for the next ten years, they will give you 2.65% annually, which is not a particularly stellar rate of return.

What Comes Next

The truth is that no one knows exactly what will happen to interest rates over the next few months because it will all depend on how the economic data looks in several key reports. The key things to watch will be the inflation numbers and the labor reports. If inflation keeps running hot, the Fed will continue to raise interest rates, which if the past week is any guide may impact commercial rates a little bit more than residential rates. But if inflation cools and the labor market weakens at all, the Fed will pull back from further rate increases and we might have plateau for awhile. The fact that 10-year Treasury Notes have fairly modest yields under 3.00% suggests that investors collectively do not believe that inflation will last for very long; if they did, yields would be higher.

I believe that upcoming inflation reports will show that things are cooling off a bit. I also expect the labor market to remain strong at least through the summer. But then we’ll see; the actual effect of these rate increases are going to set it in at some point as the lost economic activity that has come from rising rates will eventually hit the economy. So far the labor market has been holding up very well, but as summer turns to fall and then eventually winter, the depth and length of any sort of U.S. recession will start to become evident.

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