August 14, 2023
When some investors hear the term “rates” they think of CD rates or Fed policy rates. To others, interest rates are synonymous with yields on fixed-income investments more broadly. Where are policy rates, cash investment rates and bond yields headed? We believe the answer is lower over time.
The U.S. Federal Reserve uses policy rates to stimulate and slow the economy. At the start of 2022, the Fed shifted from actively spurring growth to applying its speed break primarily by raising policy rates. After the most aggressive Fed rate hike cycle in four decades, the Fed’s policy rate sits between 5.25%–5.50%, the highest level in over 20 years.
Attracting investment dollars to cash investments from other riskier options is just one goal of Fed rate hikes.
This also incents saving, which tends to be the alternative to consumer spending. More saving and less spending dims economic activity over time and often leads to lower inflation.
Very short-term investments tie directly to the Fed’s policy rate — or are highly influenced by what the Fed seeks to accomplish. As a result, money market funds, CDs, and individual securities with short maturities today generally offer the highest yields in more than two decades. Some investors contemplate whether the risk of stock and bonds offsets the potential excess return over safer cash investment options.
Raising the cost of borrowing for consumers and businesses is another goal of Fed rate hikes.
When these costs are higher, companies and consumers tend to buy less, which can slow the pace of growth and dim inflation.
- Collectively, the higher yield on very low-risk cash investments discourages both investors and borrowers from lending.
- For companies, a higher cost of borrowing serves as a disincentive to finance business expansion. Higher borrowing costs also raise the hurdle for committing to new capacity, as new opportunities must be even more profitable to buy on credit.
- For consumers, the Fed policy rate links to the rate consumers pay on credit cards, floating-rate mortgages, and personal loans.
- Inflation also leads longer bond yields higher. Higher bond yields mean higher fixed rates for borrowers of home mortgages, auto loans and school loans.
- Even the government pays higher rates. To finance our federal debt, the U.S. Treasury will pay higher interest costs on newly issued debt.
Higher yields have considerable effects on mortgage rates.
More expensive mortgages have led homeowners to stay in homes financed earlier at lower rates and tend to push buyers needing to use financing to purchase a home to the sidelines.
- At the end of 2021, financing a $500,000 home purchase with a $400,000 loan resulted in a mortgage payment of roughly $2,000 per month based on a 3.27% 30-year national mortgage rate.
- On August 3, the mortgage payment on the same new mortgage would be around $3,000, or 50% more per month based on a 7.39% mortgage rate.
Where are we going from here?
Inflation is headed lower. Consumer Price Index (CPI) inflation in the U.S. may have already peaked. After reaching 9% in June 2022, the inflation figure dropped to 3% in June of this year, approaching the Fed’s long-term target of 2% over time.
Fed policy rates are headed lower. According to Ameriprise Financial Chief Economist Russell Price, “We believe Fed officials will likely conclude their interest-rate hiking cycle once core inflation rates appear to be on a steady and sustainable deceleration trend toward its targets, a development we believe should come at some point late this year.” Against that backdrop, we may see rates as elevated for a bit longer but likely to head lower with time.
Fixed-income investment yields may be headed lower. We also see fixed-income investment yields as attractive and likely in the current trading range as they wait for labor markets to cool, and for inflation to stabilize near the Fed’s 2% long-term target.
The bottom line. Crosscurrents in the economy and markets show that we are in a period of transition from one trend to another. Transition periods come with uncertainty. While the direction we envision may not materialize as quickly as some would hope, we believe long-term investors can orient toward lower rates ahead.
Talk to your financial advisor about how rates may affect you and your investment portfolio
Reach out to your Ameriprise financial advisor if you have questions about Fed policy or how lower yields over time might impact your financial goals or your investment portfolio.