Interest Rate Math Reposted

Mark Meredith, CFP®

Below is a short blog post I wrote in June of 2018 regarding interest rate math. It’s always entertaining to look back and read what the current thoughts were at that time. I remember 2018 quite well, and everyone and their mother seemed to think rates would only go higher well beyond 2018. So what actually happened?

5 year Treasury Rate 12/31/2018 = 2.55%

5 year Treasury Rate 12/31/2019 = 1.68%

5 year Treasury Rate 04/07/2020 = 0.36%

“But Mark no one foresaw a pandemic and the fact the Fed would have to cut rates”. Yes that is my point, the future is not predictable. Once again the consensus is that interest rates will continue to rise for quite a while. We will have to check back in a few years and see what actually happens.

While we’re talking rates, here is my shameless self promotion of a Linkedin post I made yesterday regarding the inverted yield curve. It isn’t always the doomsday that some predict.

The blog post below was originally written: 06/25/2018 (I have made several small edits)

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 consistently find price inefficiencies, they seem to think it’s easier to find inefficiencies in the bond market. That probably is not the case. Some of this can be explained by recency biases, as we inherently believe the recent trends in markets will persist going forward.

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:

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.  From my experience, most people who are anticipating rates going up have not done the math to determine how much they must go up for staying short on maturities to make sense. When I do show them the math, they are generally surprised how much rates must go up to validate their decision to stay short.

The only way you come out ahead by staying short is if rates go up more than what is already anticipated. An upward sloping yield curve already indicates rates are expected to go up in the future.

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 we have a better guess on future interest rates than the collective wisdom of all market participants is not a good reason. That would be a strategy that merely relies on making a guess, and guessing is not a reasonable strategy when it comes to managing one’s life savings. Of course if one does make a guess, and it ends up being right, it is attributed to skill. If they end up being wrong, well it’s just bad luck!

The validity of a decision should not be based on its outcome, but by the thought process and information involved in making the decision. Otherwise, one is playing Monday Morning Quarterback and is always an expert.

Disclosure: Past performance does not predict future results. This article is for informational purposes only and should not be considered a recommendation. Information contained in this article is obtained from third party resources that Meredith Wealth Planning deems to be reliable.

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