In order to understand investing during the rising portion of the interest rate cycle, let’s look at the last major upswing in rates.<\/p>\n
Consider the period beginning Sept. 30, 1998, and continuing to the end of December 1999. This 15-month period was the last time rates rose 200 basis points.<\/p>\n
During this time frame, the five-year Treasury note rose from about 4.00 percent to about 6.25 percent in a fairly straight line. The 10-year Treasury note rose from about 4.25 percent to about 6.50 percent during the same period.<\/p>\n
By contrast, short-term rates were operating in a different universe. Starting at 5.50 percent, short-term rates dropped to 4.75 percent by November 1998. The first upward move did not come until June of 1999. By the end of December 1999. Federal Funds moved all the way back to 5.50 percent.<\/p>\n
Long vs. Short-term Rates<\/p>\n
Even though long-term Treasury rates declined significantly throughout 2000 (the 10-year Treasury declined from about 6.50 percent to about 5.00 percent) Federal Funds continued going up until they peaked at 6.50 percent in May of 2000. Federal Funds did not begin to decline until Jan. 3, 2001.<\/p>\n
Short-term rates are controlled and manipulated by the Federal Reserve. Long-term rates are subject to forces in the marketplace, and are free to rise or fall based on market sentiment.<\/p>\n
Long-term rates began to rise almost one year (September 1998 to June 1999) before short-term rates rose. Beginning in September 1998, many market participants were becoming concerned about the effects of the demise of a major hedge fund. As a result, the Federal Reserve became accommodative, beginning Sept. 29, 1998, by easing short-term rates from 5.50 percent to 5.25 percent.<\/p>\n
Further accommodation was evident Oct. 15, 1998, and again on Nov. 17, 1998. The Federal Reserve shifted strategies and began raising interest rates on June 30, 1999, through May 16, 2000, by moving Fed Funds targets from 4.75 percent to 6.50 percent.<\/p>\n
Long-term rates began to decline fully one year (January 2000 to January 2001) before short-term rates began to decline. The first Fed ease occurred Jan. 3, 2001.<\/p>\n
This was clearly not the instantaneous, sustained and parallel yield curve shift that we have been using in our asset\/liability models since 1988. At one point early in this period short-term rates were declining while long-term rates were rising. Near the end of the period, short-term rates were rising while long-term rates had begun to decline.<\/p>\n
Real-World Effects<\/p>\n
These non-parallel yield-curve shifts had a real-world effect on banks. The effects can be clearly seen when we look at the asset yields, liability expenses and net interest margins among savings institutions.<\/p>\n
Consider the charted data from Sept. 30, 1998, Dec. 31, 1999, and Sept. 30, 2000.<\/p>\n
During this entire period, net interest spreads of the savings industry did not change significantly. When yields on earning assets declined, so did the cost of funds. When the cost of funds rose 66 basis points (4.69 percent to 5.35 percent) in reaction to rising short-term rates, the yield on earning assets increased 58 basis points (7.42 percent to 8.00 percent) to almost match. The change in the spread was a modest 8 basis points over a period when interest rates changed dramatically.<\/p>\n
The bottom line is that it is extremely difficult to talk about rising rates in general. In each of the last three major interest rate cycles, long-term rates have begun changing before any changes in short term rates by as many as 12 months. As we saw in the last rate cycle, when the Federal Reserve is still pushing short-term rates higher, the market may already be bringing longer-term rates down.<\/p>\n
Time on Your Side<\/p>\n
In June 2003, this column showed that interest rates rarely change by as much as 200 basis points in any one year. Even when rates do change by this amount, there is a lag in the effects on the yield of earning assets and the cost of funds.<\/p>\n
If bankers are alert to changes in both 10-year Treasury rates as well as the current Federal Reserve policy, they can manage the earnings on assets and the cost of liabilities in a proactive manner to maintain net interest spreads over time.<\/p>\n
The only way bankers can create significant management problems is if they fail to react to changing rates. For example, the 10- year Treasury has been in a “trading range” between 3.75 percent and 4.25 percent for almost nine months now. When it breaks out of this trading range, be alert to the fact that something important has changed.<\/p>\n
It is important to consider if rates will decline even further, or if the increasingly large fiscal deficit requires so many 10- year notes to be issued that the yield may rise through the 4.25 percent ceiling.<\/p>\n
Interest rates rarely change by as mush as 200 basis points in any one year.<\/p>\n
Views expressed in this article are the author’s. Roy Hingston is a senior vice president for portfolio strategies at Shay Financial Securities Group in Miami.<\/p>\n
Copyright America’s Community Bankers Jul 2003<\/p>\n","protected":false},"excerpt":{"rendered":"
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