Interest Rates in 2018 – Cause and Effect

There has been a slow increase in interest rates since September of 2017 – and a quicker jump in the last few weeks.  Bond markets haven’t seen pressures like this in over 4 years – and things are trending higher.

Many potential home buyers and investors are asking why – and what does the future hold?

First, let’s take a look at what the 10 year treasury note has done since September 2017. The 10-year Treasury note rate is the yield or rate of return, you get for investing in this note. The yield is important because it is a true benchmark, which guides other interest rates, especially mortgage rates.

Note the upward slope of the yield on the graph below…and mortgage rates have essentially followed:

OK – so we see the trend line.  So why has this happened?

Well, there are 3 main reasons – and all of them are pretty decent economic signs, as a matter of fact.

Increased Employment and Potential Inflationary Pressures

Many investors believe inflation is bound to tick up if the labor market continues to improve, and some market indicators suggest inflation expectations have been climbing in recent months.  This is a general reflection better economic data, rising energy prices and the passage of sweeping tax cuts.  Many think could provide a further boost to the economy – giving consumers more money at their disposal.

Rising inflation is a threat to government bond investors because it chips away at the purchasing power of their fixed interest payments. As mentioned earlier, the 10-year Treasury yield is watched particularly closely because it is a bedrock of global finance. It is key in influencing borrowing rates for consumers, businesses and state and local governments.

If positive labor and economic news keep pouring out (as most analysts believe things will continue  to improve), then the prospect of inflation will put pressure on bonds and interest rates.

‘Quantitative Tightening’ by the Federal Reserve

Between 2009 and 2014, the US Federal Reserve created $3.5 trillion during three phases of what was called “Quantitative Easing”.  It was the Federal Reserve’s response to help reduce the dramatic market swings created by the recession about 10 years ago.  It used that money to buy $3.5 trillion dollars worth of financial assets – principally government bonds and mortgage backed securities issued by the government-sponsored mortgage entities Fannie Mae and Freddie Mac.

When you really think about it, $3.5 trillion is a pretty large amount of money. When that much money is spent over a six-year period, it would no doubt change the price of anything, bond markets included.  By the way, this maneuver has generally been appreciated in the market and (at least at this time) appears to have been a success.

Well, the Federal Reserve has now begun to reduce its balance sheet as the necessity for investment has given way to the possibility of inflation. Over time, the plan is to reinvest less and less – as per the schedule reproduced in the table below – until such a time as it considers its balance sheet ‘normalized’.

Historically, when the bonds owned by the Fed mature, they simply reinvested the proceeds into new bonds.  It essentially keeps the size of the balance sheet stable, while having very little impact on the market. However, when quantitative tightening began in October of 2017, the Fed started slowing down these reinvestments, allowing its balance sheet to gradually shrink.

In theory, through unwinding its balance sheet slowly by just allowing the bonds it owns to mature, the Fed can attempt to mitigate the fear of what might happen to yields if it was to ever try and sell such a large amount of bonds directly.

Essentially, the Federal Reserve is changing the supply and demand curve and the result is a higher yield in the 10 year treasury note.

Stock Market Increases – Pressuring Bond Markets

Generally speaking, stock markets and bond markets move in different directions. Because both stocks and bonds compete for investment money at a fundamental level, most financial analysts believe that a strengthening equity (stock) market attracts funds away from bonds.

By all measures, 2017 was a stellar year for the stock market. As we enter a new year, experts are cautiously optimistic that stocks will continue their hot streak in 2018.

Stocks soared last year on excellent corporate profits and positive economic growth. The Dow Jones industrial average shot up by 25%, the S&P 500 grew by 19% and the Nasdaq index bested them both with a 28% gain.

There is clearly more evidence of excitement among investors in 2018. This has everything to do with a strengthening economy and record corporate revenues…and profits that that have been bolstered by the new tax law.

In the short run, rising equity values would tend to drive bond prices lower and bond yields higher than they otherwise might have been.

What It All Means

So, I think it is safe to say that we will continue to see pressures in the bond market and mortgage rates overall. These increases look to be gradual, but consistent.

With that said, home prices are increasing nationally at nearly 6%, so the increase in interest rate will be more than offset by the increasing value of one’s home! Now is a fantastic time to purchase. Contact me for more information, as it would by my privilege to help you.