It’s official. ZIRP (Zero Interest Rate Policy) is dead. In fact, the Federal Reserve (FED) has raised interest rates to levels not seen in many years. Car and home buyers are getting hit hard, and at this moment the average potential buyer cannot afford a new car. This is a result of higher interest rates, coupled with high inflation. New car prices average $48,008, and payments are generally over $700 monthly. Grocery prices are out of sight. Eat or drive?
Switching focus to the winners’ side of high-interest rates, lenders are now receiving better returns on loaned funds. Not everyone may realize their own status as a lender. If you own any Money Market shares, interest-bearing bank accounts, or investment bonds, you have loaned money to the issuer. In return, that borrower has promised to pay you interest until the money is repaid, or the bond either gets sold or matures.
Maximizing interest earnings on bonds requires an understanding of the “Yield Curve,” which is a graphical representation of market interest rates. On the graph, interest rates are on the vertical axis, and time is the horizontal component. Understanding a normal Yield Curve is easily demonstrated. Suppose you are buying a car, and you compare loan rates for differing lengths of repayment. You may get a quote like this; 2 years for 1.9%, 3 years for 2.9%, 4 years for 3.9%, etc. Longer repayment periods carry with them higher interest rates. That’s how bond yields work in a normal rate environment.
Plotting those various points on the graph, then connecting the dots into a smooth line, creates the Yield Curve. Normally, it will simply show an upward-sloping curve, looking from left to right. In 2023, we have been experiencing an “inverted” Yield Curve. This results from the perception in the market that current high rates are temporary, so short-term rates are unusually high. Expectations for long-term interest rates are lower than for short-term rates, and plotting those data points creates a Yield Curve with the “wrong” slope (inverted).
Why does this matter to the average American? For savers, elevated short-term rates provide an opportunity for investing in CDs and other short-term, interest-bearing instruments, at attractive rates. For borrowers, it means there is more pain in current (higher) repayment requirements.
Unfortunately, an Inverted Yield Curve generally foretells an economy in decline and signals an upcoming recession. While that result is not guaranteed, the correlation is very strong throughout history. When a recession is actually encountered, the overall state of the economy (and the job market) is unhealthy. Prudent Americans may delay plans for large purchases, in favor of future rate decreases. Economies run in cycles, and the Yield Curve will return to normal. Meanwhile, consumers should be cautious about making costly commitments.
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