Today we likely reach the end which, naturally, is a new beginning.
Unless we see rising inflation or falling unemployment over the next few months, today is likely the Federal Reserve’s last increase in its overnight bank lending rate during this economic cycle.
It has been a very rapid ascent. After holding their interest rate at 0% for 2 years from March 2020 through March 2022, the Federal Reserve embarked on nine straight meetings with rate hikes on March 16, 2022. After today’s rate hike, overnight interest rates will have increased from 0% to 5% in under 14 months.
That is an incredible amount of economic braking being applied. And this does not even take into consideration the impact of liquidating the portfolio of US Treasuries and mortgages the Federal Reserve purchased to keep interest rates artificially lower. They are now permitting $95 billion worth of their portfolio to mature every single month, putting additional upside pressure on interest rates.
Unlike car brakes which are applied immediately, the Federal Reserve’s economic brakes take roughly nine months before they are fully applied. This means that right now we are only feeling the full braking power that the Federal Reserve applied through July 27, 2022. After today, there is another 2.75% of rate increases that have yet to fully phase in. We are only feeling about half of the Federal Reserve’s economic braking pressure that has already been applied.
In every end there is a new beginning. The Federal Reserve may keep their overnight interest rate flat for a bit, but inevitably they will start to reduce it once they are confident that the odds of a self-reinforcing inflation cycle are very low. They must also take into consideration political factors during a Presidential election year as rising unemployment and a slowing economy are generally unpopular with the voters.
Right now, bond traders are predicting that the Federal Reserve may begin cutting interest rates later this year – perhaps as early as November. Those with short-term debt will favor this transition to lower interest rate costs, including the federal government with its $32,000,000,000,000 of accumulated debt.
Those with cash savings will not appreciate this new beginning. The “extremely high” (relative to the last 10 years) interest rates on cash accounts will likely begin to fade. Short-term certificates of deposit (CDs) that mature six months or more from now will potentially renew at lower interest rates.
The only way to offset this risk of falling interest rates is to lock in today’s cash rates for a longer period of time, but that means accepting a lower interest rate than a shorter-term deposit. That leaves cash investors with a conundrum.
However, just as rising interest rates posed a significant challenge for bond investors last year, falling interest rates could prove to be a real blessing at some point in the future. If interest rates fall, bond investors could benefit from rising bond values while maintaining their current income. Of course, bond investments also have more investment risk than cash deposits and, if sold prior to maturity, could lose value.
Today likely marks the end of increases in short-term interest rates. Let those who use debt rejoice. It also marks the beginning of declining interest rates on cash deposits. Let those who have cash savings be warned.
Quote of the week: Benjamin Graham: “The investor’s chief problem – and his worst enemy – is likely to be himself. In the end, how your investments behave is much less important than how you behave.”