Monday, February 06, 2017

Rising Interest Rates Matter to Everyone, Especially the Government

When will the Federal Reserve again raise interest rates? That is the question on the minds of lenders and borrower alike. In reality, the Fed will actually raise just a single interest rate, the federal funds rate, which affects all other short-term rates. Those, in turn, can affect long-term rates, such as mortgages.

The Fed raised the funds rate in Dec. 2016 to its current 0.75 percent, from 0.50 percent. It was just the second increase in a decade, following the one in Dec. 2015. The Fed has penciled in three more quarter-point rate increases this year. Meanwhile, traders expect slightly less than two increases in 2017.

The Fed typically raises or lowers the funds rate in quarter-point increments, meaning the increase from 0.50 to 0.75 percent was the smallest that might occur. However, it still represented an increase of 50 percent. That’s a relatively large climb. Imagine how the markets would tremble if the funds rate jumped from 3 percent to 4.5 percent, or even from 2 percent to 3 percent?

When rates are this low, even relatively small movements have large proportional effects.

Just to provide a little perspective on how historically low the federal funds rate remains — even after hikes in each of the past two Decembers — the rate has averaged 6 percent since 1971. In 2001, it was 6.5 percent. Again, it is presently 0.75 percent, so we are still a long way from normal.

The 10-year Treasury bond yield peaked at 15.84 percent in 1981. There are lots of Americans who have no memory of, and no experience with, such high borrowing costs.

Americans, and markets, have become accustomed to exceptionally low rates. What were once viewed as anomalies are now considered the norm. For example, the 10-year Treasury yield fell in July, 2016 to 1.367%, while the 30-year fell to 2.141%. Both were record lows. However, the pendulum now appears to be swinging the other way.

Though the Fed has announced plans for three more rate hikes this year, its concurrent aim to reduce its bond holdings will automatically put upward pressure on rates. In other words, the Fed may achieve its objective without having to raise the funds rate any further.

Through its quantitative easing program, which was designed to lower rates and increase lending, the Fed has amassed $4.45 trillion in bond assets, of which $1.75 trillion are in mortgaged-backed securities. When the Fed eventually (and inevitably) starts to unload some of these holdings, rather than reinvesting them, long-term rates will begin to rise. That discussion has now begun and many market watchers expect the slow process of unwinding to begin as soon as this year.

Increasing mortgage rates will likely slow the housing market, reducing demand and prices. The Fed is now the biggest source of demand for U.S. government-backed mortgage debt and owns a third of the market. So, if the Fed stops buying mortgage bonds, it will almost surely lead to further cost increases for home buyers.

Simply put, when the biggest buyer exits the market, demand for mortgage-backed securities will fall and borrowing costs will rise. Who remembers 6 percent 30-year mortgages? It wasn’t very long ago (2008 to be exact) that this was the norm. In 2000, the 30-year mortgage was over 8 percent. Such a reversion would crush the housing market.

The 10-year Treasury presently yields about 2.4 percent, while the 30-year yields about 3 percent; that’s not a big difference. Borrowing money for 30 years should cost a lot more than borrowing for 10 years, yet the costs are quite similar at present.

That could all change this year and next, pushing mortgage costs much higher. Markets are forward looking, anticipating future rate moves. As a result, mortgage rates are already on the rise.

The total value of the U.S. housing stock grew nearly 6 percent last year, according to Zillow. The housing market has finally regained all the value lost during the housing crisis, Zillow found.

Homeowners have once again become accustomed to the value of their homes appreciating considerably each year, but that upward trajectory could now be in jeopardy.

Of course there are two sides in any transaction. For buyers, a price halt, or even retrenchment, would be welcomed.

Lastly, and quite critically, higher borrowing costs will have a very negative effect on the federal government. The national debt has now reached $20 trillion and is steadily rising.

The federal budget deficit is projected to add nearly $10 trillion to the federal debt over the next 10 years, according to the latest projections from the nonpartisan Congressional Budget Office.

Meanwhile, the CBO projects that, under current law, net interest costs will more than double over the next 10 years, soaring from $270 billion in 2017 to $712 billion in 2026 and totaling $4.8 trillion over the period. Interest costs are expected to continue climbing beyond the next 10 years and are projected to be the third largest category in the federal budget by 2028 (after just Social Security and Medicare), the second largest category in 2046, and the single largest category in 2050.

That’s a recipe for disaster and a full-blown economic crisis. It illustrates why rising interest rates are so critical. Borrowing costs matter, not just to car buyers and home buyers, but also to our heavily indebted federal government, which is funded by the taxpayers — meaning you and me.