How interest rates compare over the last decade within the United States

Interest rates form the basis for valuation models around the world. They are used in almost every industry, country, and geography. Interest rates can also influence corporate and consumer behaviors. For example, depending on the inherent risk of a consumer, credit card rates determine how much an individual must pay on a month basis to the financial institution. Corporations looking to borrow funds to expand their market share must consider the variable interest rates being changed and their ability to service the debt. Even governments must be mindful of the extent of their borrowers and the corresponding impact of interest rates on their ability to services the debt. Due primarily to their importance in key elements of human civilization, interest rates are a closely watched tool by individual investors, general consumers, and corporations. Banks in particular are heavily influenced by the change in interest rates as they operate as financial intermediaries between consumers and business. As a result, they often focus keenly on what interest rates may likely look like in the future and how they will influence the viability of the franchise (Stock, J.H. and Watson, M.W, 2007).
Banks play a vital role in the overall economy. They act as a financial intermediary between savers and borrowers. The often help to match investors (those looking to deploy capital into investments) with business enterprises (those looking to use capital to invest). These transactions ultimately help in delivering a vibrant and health economy. Those businesses that are worthwhile and can enhance the quality of life for others are often met with capital facilitated by the banks. Initial Public Offerings, Secondary Stock Offerings, Bond offerings and so forth help to facilitate these transactions. Likewise, those looking to borrower to finance a home purchase or a car purchase may need additional funds that they otherwise may not have now. As a financial intermediary, banks can help transfer funds from savers (those who do not need to use the money immediately) to borrowers (those who would like to use the funds to purchase products). Again, this helps to provide a fully functioning economy as individual have access to capital they may not have otherwise obtained (Laubach and Williams, 2008).
Although the process of being a financial intermediary appears simple at first, glance it is often complicated by interest rates and beliefs regarding expected interest rates. The problem of interest rates is compounded by the fact that different purchases, securities, and investments all have varying durations. A car loan can be 5 to 7 years, a mortgage may be 30 years, a certificate of deposit may be for 3 years, and so forth. A bank has the problem of matching the duration of its sources of funds with their respective uses. On occasion, a mismatch of duration has ultimately resulted in financial catastrophe. If left unchecked this asset-lability mismatch cause serious trouble for financial institutions, particular as it relates to interest rates. A typical example relates to banks having large amounts of long-term assets such as mortgages funded in large part by short term liabilities such as deposits or certificates of deposit. In the event of a rise in short term interest rates, these liabilities become more expensive. The interest rates on the longer-term assets, which are often fixed remains unchanged. Another mismatch is when a bank borrows at one rate such a variable rate but then lends money at a different rate that is fixed. Here too, a change in interest, particular is unexpected can have an adverse impact on the bank. In this case, the amount owed to bondholders would increase while fixed payments received remains unchanged. In the 2008 financial crisis, Bear Sterns, a very honored and established investment bank went bankrupt partly because of its inability to adhere to these principles. Here the bank financed itself through deposits, commercial paper and treasury bills. Although each has a very low interest rate, they are needed immediately (See chart 1 below interest rates). Customers for example expect to receive their deposits on demand. It then lent the money out long term to institutions, companies, and institutions, keeping the spread between the interest rates. However, as the financial collapse occurred, it could no longer tap into the short-term financing needed to run its business. The firm soon ran out of cash due to this mismatch of interest rates (Schularick, M, and A M Taylor, 2009).
When looking over the last decade and comparing interest rates between the Federal Funds Rate, Treasury Bills and Treasury Bonds and interesting trend emerges. Under all three circumstances, the interest rate has fallen rather sharply. Due to these historic lows, “Savers” are not earning much on their deposits with the bank. Likewise, banks are not earning as much lending out for the long term as Treasury bill rates are near 0%. As a result, the net interest margin, the difference between what the bank pays for deposits and lends out to other institutions has narrowed considerably. This ultimately has an impact on profits for the banks and the price at which their shares trade in the market. With these historic low interest rates, savers are discourage to save, as they will earn very little in doing so. An unintended consequence therefore, is the need for high risk taking on the part of institutions to achieve higher yields. Due to the lower interest rates prevailing in the market, all other fixed income assets have seen lower yields. AAA rated bonds, high-grade Municipal bonds, and even some junk rated bonds have seen lower yields. Investors are therefore forced to move up the risk scale in order to achieve the same yields they had in times that were more promising. Chart 1 below shows the difference in yields between the federal funds rate, Treasury Bills, and Treasury Notes. Each has experienced a large decline indicated primarily by the tough economic times prevailing today (Holston, 2017).
Do to these lower yields banks must be vigilant to avoid many of the mismatch problems described in the paragraphs above. The mismatch problem becomes particular troublesome when inflation enters the equation (Goodhard, 2008). Due to the fact that 10 year fixed income instruments are yielding such a lower amount, in inflation above the 2% federal mandate amount can cause a sever loss of principle. For example, according to Moody’s, one of the large rating agencies, the effective rate on AAA bonds is 1.63%. If inflation reaches 2%, which is the Federal Reserves target, the banks purchase of this bond will actual destroy value as oppose to create it. Banks should therefore look for shorter duration assets and liabilities to hopefully take advantage of an eventual increase in interest rates. Due primarily to the COVID-19 pandemic, the rates listed in Chart 1 are forecast to persist for at least another year or two. Banks are therefore forced to operate in a low interest rate environment. As a result, banks should keep their durations short to first avoid the mismatch problems that have plagued other banks in the past, but also to take advantage of any eventual interest rate increases (Rachel, L. and Smith, 2017).
So far, we have discussed interest rates in two periods and their repercussions for each period. We described the mismatch theory and how that caused Bearn Sterns to go bankrupt. We discussed how the interest rates prevailing today are causing more individual to see out riskier, high yielding assets. We discussed the implications for savers as they earn little are therefore forced to move up the risk scale. We even touched on inflation and how it will affect banks who are looking to purchase longer duration assets. What was not touched on was the ability of banks to avoid some of these problems with hedging. In many instances, banks can avoid many of the inflation, mismatch, and duration problems mentioned above through proper hedging. Here banks can use forwards, futures and interest rate swaps to essentially “lock-in” a particular rate. This is helpful as it can be used to help avoid any disastrous consequences that could arise through a sudden shirt in the yield curve. Interest rates of often determined by credit risk or the likelihood of default. To reduce the risk profile of the bank, hedges are used. In the case of interest rates, hedges can be used to protect the bank in the event of losses that are the result in a change in interest rates or the yield curve.
Name
Description
Current Rate (7/6/2020)
Historical (12/31/2009)
Federal Funds Rate
The federal funds rate is the interest rate charged to other banks and depositary institutions for overnight lending. Banks are required to hold a certain percentage of deposits on reserve, earning no interest. Any excessed are used to lend to other banks at the appropriate rate.
.025%
1.45%
3 Month T-Bill
A 3-month Treasury Bill is a short-term instrument backed by the full faith and credit of the United States government. These instruments are generally considered risk free but offer very little return in exchange for safety. T-Bills are typically auctioned off at a discount to par value with the difference being the return the investor received. Interest is only taxed at the federal level and is exempt from state and local taxes.
.145%
1.55%
10 Year Treasury Notes
The 10-Year Treasury Bond is very similar to the Treasury bill in that it is backed by the full faith and credit of the United States government. T- Notes generate interest income twice a year but offer lower yield then T-Bonds (30 Years)
.69%
1.92%
References
1. Goodhard, C and E Perotti, 2008 “Maturity mismatch stretching: Banking has taken a wrong turn”, CEPR Policy Insight 81, 6-July
2. Holston, Laubach, and Williams. 2017. “Measuring the Natural Rate of Interest: International Trends and Determinants,” Journal of International Economics 108, supplement 1 (May): S39–S75
3. Laubach and Williams. 2003. “Measuring the Natural Rate of Interest,” Review of Economics and Statistics 85, no.4 (November): 1063-70.
4. Rachel, L. and Smith, T.D., 2017. Are low real interest rates here to stay?. International Journal of Central Banking, 13(3), pp.1-42.
5. Schularick, M, and A M Taylor, (2009), “Credit Booms Gone Bust: Monetary Policy, Leverage Cycles and Financial Crises, 1870-2008”, NBER DP 15512
6. Stock, J.H. and Watson, M.W., 2007. Why has US inflation become harder to forecast?. Journal of Money, Credit and banking, 39, pp.3-33