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Lower Interest Rates Help on the Margin

Lower Interest Rates Help on the Margin

Bradley N. Stewart, CFA, Associate Vice President, Associate Director of Wealth Management Research

Are lower interest rates a good thing? Although most people are likely to quickly respond, “yes,” the actual answer is more nuanced and depends on who you’re asking. All things equal, savers prefer to earn a higher level of interest while consumers want to pay as little interest as possible. Interest rates profoundly impact financial decisions. Since we are all simultaneously savers and borrowers, let’s take a look at how lower rates can have both positive and negative impacts on the economy.

To appreciate how interest rates affect financial decisions, it is helpful to consider that interest rates represent the equilibrium between the supply and demand for loans. Someone saving money (versus consuming goods or services) makes lending possible, and that saver earns interest as compensation. Interest rates increase and decrease based on the supply of money and the demand for loans. That can impact a reference rate or the spread between two interest rates. A well-known example of a reference and spread rate relationship is a residential mortgage rate. Historically, a 30-year fixed rate mortgage typically prices 1 to 2 percentage points above the 10-year Treasury yield.1 At the time of writing, the 10-year yield is 4.27%2 and the average 30-year fixed mortgage rate is 7.08%.3 The current 2.81% spread is 0.8% above the high-end of the historical range, indicating it is currently an expensive time to apply for a mortgage, even after adjusting expectations to the elevated 10-year Treasury yield.

With that background on interest rates, we can reframe and discuss our original question: What is good about lower interest rates in 2024? All else equal, lower interest rates benefit borrowers. Lower rates have positive effects such as stimulating demand, increasing disposable income, stimulating business investment, and increasing asset prices. As discussed earlier, mortgage rates are currently at a 2.81% spread over 10-year Treasury yields. If mortgage rate spreads tighten to 1 percentage point over the current Treasury yield, people who bought homes at higher mortgage rates would be able to refinance to a lower monthly mortgage payment. The homeowner could spend or save the difference. However, according to Redfin, roughly 85% of homeowners in 2022 held a mortgage with an interest rate below 3.5%.4

Lower rates typically stimulate higher asset prices because the same monthly payment services a higher loan amount. The mortgage refinancing example discussed in the previous paragraph is helpful when considering how asset prices might react to lower rates in 2024. Consider first that for much of the period from 1982 to today, interest rates declined to gradually lower lows over business cycles. For most of the past 15 years, interest rates were at the lowest level ever as a result of the Federal Reserve’s (Fed) response to the Global Financial Crisis of 2008 and the 2020 pandemic. Like homeowners, most commercial real estate owners took advantage of record low rates and bid up the price of the buildings bought. However, most commercial real estate loans were for 5 to 10 years. That means lower rates are helpful on the margin versus a few months ago but still higher than the interest expense on their current debt. The end result means total interest expense will likely increase and reduce profit margins if rental income remains the same. For this reason, it seems unlikely that a 0.75 to 1 percentage point decline in interest rates will meaningfully benefit asset prices that are currently funded by significantly lower interest rate debt. That said, modestly lower interest rates should help on the margin.

There are risks to lower interest rates, too. Retired people who live off interest income from fixed investment will see their incomes and discretionary income decline. Inflation is another potential risk and the primary reason the Fed cites for waiting to normalize short-term interest rates. We specifically use the term “normalize” interest rates to highlight something discussed previously, but which does not seem to be fully appreciated by many market prognosticators. There is broad economic agreement that “higher” interest rates slow growth and “lower” interest rates stimulate growth, but determining how stimulative the level of rates is for an economy depends on how it compares to the current rate of interest that consumers and business are paying. There is no current expectation that interest rates will decline to new, historically low levels. The Fed is debating the benefit of lowering rates to a historically “normal” level of ~4.6% in 2024 and ~3.6% in 2025.5 That implies that the Fed and markets expect borrowers who refinance debt in the next few years to adjust to higher interest rates than they are currently paying. Borrowers with very long-term loans, like 30-year fixed-rate mortgages below 3.5%, will not need to adjust (until they sell their homes), but most consumers and businesses will pay higher interest on their new debt. Therefore, modestly lower rates seem unlikely to be inflationary or broadly stimulative, in our opinion. In fact, borrowers today should probably be debating the effects of adjusting to “higher interest rates in the future…but lower than they could have been.” Lower interest rates in 2024 are good, but they likely only help on the margin.

1 Mortgage Rates Not Matching Declines in Treasury Yields
2 U.S. Benchmark Bond – 10 Year; FactSet
3 Today’s Mortgage Rates
4 85% of Homeowners with Mortgages Have a Rate Far Below Today’s Level, a Factor Prompting Many to Stay Put&
5 Fed Holds Rates Steady, Indicates Tightening Cycle Over

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