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When Will Interest Rates Come Down?

by Brandon Michaels and Chris Adnams

Key Takeaways

· Historic forward curves of the 1-month SOFR/LIBOR illustrate how challenging it is to estimate future interest rate adjustments

· Projections of short term interest rate decreases could be inaccurate

· Review of the last three Federal Funds Rate cycles show an average 9-month hold at the peak and a 25-month period of decline

· Although the Federal Funds Rate appears to be near its peak, we should still expect an extended period of elevated rates before a slow period of decline

· Periods of significant rates cuts have shown to happen concurrently with periods of recession, meaning that while the cost of debt reduces, it’s likely because of a suffering economy

Coming off historically low interest rates in the wake of the pandemic, the Federal Reserve has taken very aggressive action to tame inflation in the past 17 months, raising the federal funds target rate by over 500 basis points since March 2022. This tightening cycle has been the fastest in four decades. Between 2004 and 2006, the Fed raised its policy rate by a total of 425 basis points, but apart from that, no other tightening cycle in the past 40 years comes even close to the current one in terms of scope and speed. Prior to that, the federal funds rate peaked at nearly 20 percent in 1980/1981, when the Fed was battling record-high inflation.

As a result of the rapid ascent of interest rates, owners of debt encumbered properties now find themselves in the challenging position of having to refinance at rates significantly higher than their current rates. Many are beginning to face the stark reality of having to add additional capital to refinance their existing debt coupled with diminishing cash flow projections, causing many to ask, when will interest rates come back down, and by how much?

After a brief pause during June’s Federal Open Market Committee (FOMC) meeting to the raising of interest rates, the Federal Reserve remained committed to its battle against inflation, raising its benchmark Federal Funds Rate an additional 25 basis points in July, making the target range 5.25%-5.50%. Because of the detrimental impact that higher interest rates have caused, many believe, or more likely hope, that interest rates will likely be reduced sooner than later.

Rate Projections

Representative of the belief of reduction to interest rates in the short term is the interest rate “forward curve”. A forward curve is an estimation of what the market thinks the rate will do over the next few years. The graph below shows the 1-month SOFR/LIBOR in blue, a short-term rate often derivative of the Federal Funds Rate, against past forward curves in light gray dashed lines. The graph is often referred to as the “hairy graph” because of how misaligned past forward curves have been in estimating the true performance of interest rates, creating “hairs” that stretch out from the actual index. The graph illustrates how challenging it is to estimate future modifications to interest rates and that projections of future interest rate decreases could be inaccurate.

Historic Federal Funds Rate

A historic review of the last three recessionary periods shows a much clearer narrative. The Federal Funds Rate has shown to move in regular cycles, with a period of stability at its peak before falling over an extended period. Prior to the beginning of the 1990’s financial crisis, the rate held for 9 months beginning January 1990 before falling for 2 years and 2 months until reaching its bottom in December 1992. Prior to the bubble bust of 2001, the Federal Funds Rate remained stable from June to December of 2000, or 6 months. This was then followed by a period of falling for 2 years and 7 months before reaching its bottom in July of 2003. And finally, the rate held for 12 months prior to the Great Recession before falling another 18 months until January of 2009. These three most recent examples, although a small sample size, averaged a 9-month hold at the peak and a 25-month decline.

While interest rate forecasts have proven somewhat unreliable, history tells a more compelling story. If we compare our current situation to that of situations past, current trajectory indicates that although the Federal Funds Rate appears to be near its peak, we should still expect an extended period of higher rates before a period of slow decline to get back to “lower rates”.

The Lesser of Two Evils

The old Wall Street saying goes that the Fed does not stop raising rates until something breaks, that something being the US economy. Those calling for massive reductions in interest rates might be met with other problems as rates decline. More specifically, periods of significant rate cuts have shown to happen concurrently with periods of recession, meaning that while the cost of debt reduces, it’s likely because of a suffering economy.

The economy appears to be responding well to higher rates considering the historically hasty pace they have increased. The Gross Domestic Product, or GDP, typically a measure of the overall health of the economy, has continued to show positive year over year growth with quarterly projections remaining positive as well. However, this, in tandem with the recent rise in inflation to 3.2% and core CPI to 4.7%, could give the Federal Reserve a reason to believe the Economy is still overheated and not cut interest rates for quite some time.

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