Financial Markets, Interest Rates

Interest Rate Math

I can’t imagine how many people deleted the email after seeing the title of this article.  Thanks for making it this far.

The Federal Reserve has now raised interest rates 7 times in the past 19 months, with a couple more rate increases predicted for 2018.  Many savers placing their money in fixed income investments tend to think at a time like this it makes sense to wait until rates further increase before investing in any intermediate-term fixed income investments.

This is a pet peeve of mine.  While many would agree that the stock market is a difficult place to find price inefficiencies, they think the fixed income market is easier.  That is probably not the case.

If everyone is predicting the Federal Reserve will raise rates two more times this year, it is already priced into the yield curve appropriately.  The Federal Reserve recently raised rates 0.25% on June 13th.  Here are the Treasury rates 1 week prior to the rate increase versus 1 week after the rate increase:

Date 1 Mo 3 Mo 6 Mo 1 Year 2 Year 3 Year 5 Year 7 Year 10 Year 20 Year 30 Year
6/6/2018 1.81 1.95 2.13 2.32 2.52 2.65 2.81 2.93 2.97 3.05 3.13
6/20/2018 1.85 1.94 2.14 2.36 2.56 2.67 2.8 2.89 2.93 2.99 3.06

There are some minor differences, but overall fairly similar.  The long rates actually fell slightly.  The market was anticipating a rate hike, and a rate hike happened.

Let’s say an investor has a 3 year investment horizon for their fixed income and they have a choice of the following rates:

1 year = 2.40%

2 year = 2.80%

3 year = 3.00%

The investor could choose a 3 year rate and earn a total return of 9% (3+3+3) over the 3 year period.  Alternatively, they could choose to stay short because they think rates will go up, so they choose a 1 year rate instead.

During the 1 year they earn 2.40%, but now they must reinvest the money for the two remaining years.  In order to match the return they would have received from the 3 year rate, they now need the 2 year rate to be 3.30% just to break even.

Within 1 year, you are betting on the 2 year rate moving from 2.80% to greater than 3.30%.  That is not an unrealistic jump, but I’d suspect many are unaware of what their break even rate is.  The only way you come out ahead by staying short is if rates go up more than what is already anticipated.

Even if the investor with a 3 year horizon initially chose the 2 year rate opposed to the 1 or the 3, they would need the 1 year rate to be 3.40% 2 years from their initial investment just to break even as opposed to choosing the 3 year initially.

There are plenty of reasons not to extend your maturities on fixed income, but believing you have an better guess on future interest rates than everyone else isn’t one of them.

The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. There is no assurance any of the trends mentioned will continue or forecasts will occur. Any opinions are those of the author and not necessarily those of RJFS or Raymond James.