Balancing the economy between hyperinflation and recession may sound like dangerous work, but it is the current responsibility of our Federal Reserve. The Federal Reserve (“Fed”) is the central bank of the United States, the national bank, so to speak. The Fed’s job is to keep the U.S.’s economy somewhere between growing too fast and not growing at all. To do this, they increase or decrease the money supply (they print or shred money, literally).
As short-term interest rates continue to increase, it is important to understand the effects of increasing interest rates and to understand a very important definition: the bond curve. This article will dive into the effects of interest rates and how they may even be used to predict a recession.
Suppose you have $1,000 in a Certificate of Deposit (“CD”) with a bank offering 1% interest rate. After one year of holding that CD, $10 of interest would have been earned. However, most of you know that by investing in a 3-year CD instead, you may be able to earn a higher interest rate, for example, 2%. A higher interest rate is usually given to longer-term bonds or CD’s because of two very important reasons: 1) Investors require more profit in exchange for locking in their money for longer periods of time and 2) The future is expected to be better off than the present.
The latter point is why capitalism works, why we have inflation, and why you would take $1,000 today rather than taking $1,000 one year from today. Over time, money tends to grow upwards and, hence, the future is usually expected to be worth more than the present. When this is not the case, then there are more serious worries about the economy. Let me expand.
The 10-Year Treasury Bond is debt that the U.S. sells and that almost anyone can buy. The term length is 10 years and it has an interest rate of 2.7%. The 3-Month Treasury Bill is also a type of debt that the U.S. sells; it’s term length is 3 months and its interest rate is 1.5%. The bond curve is the difference between the 10-Year and the 3-Month Treasury debt, so it is currently 1.2% (2.7% minus 1.5%). See the attached chart. As the Bond Curve approaches 0%, the future becomes less optimistic than the present. This is dangerous grounds, as the Bond Curve has predicted a recession in the United States nearly every time since the early 1960s.
As you may have heard in the news, the Federal Reserve is increasing the interest rate of the 3-Month Treasury Bill. If you’re looking at the previous paragraph and now wondering why the Fed would increase the 1.5% short-term bond, and thus decreasing the bond curve, see next sentence. Decreasing interest rates can be used as “steam release” during an economic slowdown. Corporations always have the option to either save their money or spend it. Decreasing interest rates during an economic slowdown will decrease the amount of money corporations save (because who wants to save at 0% interest rate?). This leads to an increase in corporate spending and thereby spurring the economy. If short-term interest rates are already near 0%, and an economic slowdown occurred, there would be no “steam release” to use. Furthermore, if inflation becomes too high, increasing short-term interest rates is an important method to steady the economy. Therein lies the choice: letting the economy overheat too much and letting inflation get out of hand, or, letting the economy flounder. This is the dance of the Federal Reserve to keep the economy somewhere in the middle.
However, as evidence from the graph below, we have been headed towards zero bond curve since we left the last recession. Now is the time to realize the music could stop and that the market could leave us standing with no chair to sit on. With the stock market at near all-time highs, now may not be the time to sit down, but you should at least know where your chair is.