New Federal Fund Rate Projection and Its Implications

The New Projections

A rising short term interest rate is not any news to the market. The only thing people don’t know is when and how fast it would happen. To the surprise of many market participants, the schedule of the potential Federal Fund Rate hike is accelerated in today’s release compared to the last meeting’s projections.

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As we can see in the projections above, although there are widely different opinions among FOMC members, the average interest rate projections have been increased compared to the release in June, 2014. In average, the interest rate is roughly 1.375% for 2015, 2.75% for 2016, and 3.75% for 2017.

Also, in the last two meetings, there were no projections for year 2017. We only knew that the interest rate for the long term is expected to be stabilized around 3.75%. However, today’s projection shows that the majority of the FOMC members expect the interest rate to go beyond 3% in 2017, or 3 years from now.

Some Implications On Stock Investments

In history, we can find that the yield curve tends to be flattened when the short term interest rate goes up. This will severely impact those companies that “borrowed short and invested long” (borrowed short term loans like credit facilities and invested in long term assets, while getting profits from the yield spread between the long term interest rate and the short term interest rate). Certainly, anyone can do this without much experience and still make a lot of money. In fact, a lot of companies have been doing this for quite long now. Obviously, there is no free lunch in this world. The catch here is that once the short term interest rate goes up, their profit will vaporize or even turn to a big loss. By definition, the long term assets are not flexible since they are long term commitments. Once the short term rate goes up, these companies will be forced to pay a higher interest expense, but still obligated to accept the same long term interest income as before.

For example, a REIT company can borrow short term loans through credit facilities, leveraging up 6-8 times, and invest on long term mortgages (such as 30 years Mortgage Backed Securities). Because there is a 3% interest rate spread and it is leveraged up 7 times, they could easily earn 20% over equity in this way. Also, in the past few years, when interest rate decreased, the fair value of the long term MBS increased and boosted the book value. So on surface, we have seen these companies with increasing book value, very attractive earnings and generous dividends, but once the short term interest rate starts to go up, it will be a completely different or even entirely opposite scenario.

For professionals, all these are not big news. However, I still see a lot of headline news around saying the insurance companies will be benefited by the rising short term interest rates. That statement alone is correct, in the long term. However, in the short term, you will see their book value and comprehensive income getting reduced significantly, since a higher interest rate means lower bond value on their books. Therefore, people who valued insurance companies based on their book value or comprehensive income may actually see a decline in share price in the short term. That said, in general, I do agree a rising interest rate is a good thing for insurance companies, especially when they have shorter maturity bonds in the assets. So essentially, after we balance the effects of a declining book value and a potentially higher future income, a fast rising short term interest rate will benefit the insurance companies with shorter duration assets a lot more than those with longer duration assets.

Another thing investors need to pay attention to is the leverage of their invested companies. For those companies heavily on debt, and financed primarily on short term loans like credit facilities, a higher interest rate means less profit. It may even get to a point of turning profits into losses. Also, some people were talking about coverage ratios calculated from the interest payments on short term loans. Obviously, that can be very misleading. While the long term interest rate could double in a bad scenario, the interest rate on short term loans could go up more than 5 times from here. Therefore, even a good coverage ratio of 5 is not that good if it is calculated from the short term loan’s interest payments in the past few years.

In addition, since many unsophisticated investors primarily focused only on P/E, these high leverage companies’ stocks have enjoyed much on lower capital cost on short term debts in the past. This is unlikely to continue for long.

Take Advantage of The Low Rates for Personal Finance

For personal finance, if one is buying a home, he/she could still enjoy good mortgage rates for now, but perhaps not for long. I have been recommending many of my friends to get mortgages even if they can afford to pay down more mortgages by cash. Many of them felt it is hard to understand, especially when the stock market is inflated, and we suffer from the lack of good alternative investment options at the moment. There are 4 reasons behind this recommendation:

1. Additional liquidity is handy during bad times and we should be prepared. The liquidity also offers flexibility when good opportunities in real estate or stock market come along.
2. In the long term, buying many big cap value stocks right now would still give a return much higher than the current mortgage rates. Also, in 3 years, even the 1 year bank CD has a good chance to give a yield higher than today’s 30 year mortgage rate. There could also be many other good long term corporate bonds that would offer much better yields 2-3 years later.
3. Since interest rate is much more likely to go down than up, some people might consider shorting long term bonds right now. Essentially, getting a mortgage is like shorting a long term bond. However, shorting bond requires capital to support the leverage and also subjects to margin calls. On the other hand, there is no margin call to borrow a mortgage; it requires no equity to support the leverage; its interest payment is often tax deductible, and it reduces the potential maximum liabilities for unforeseen disasters like major earthquakes.
4. Inflation still remains one big threat for the financial market and personal investments. While some people may suggest to hold gold or commodity assets as a hedge against inflation, borrowing a mortgage is a good or maybe better hedge too.

When being asked recently on what can still be a good investment in today’s market, Buffett mentioned that if he is a small investor, he might try to find a real estate property in a still distressed area and borrow 30 years mortgage to invest on it.

Conclusion

Certainly I can not accurate predict what will happen to the interest rates, and everything above is not very meaningful if the interest rates don’t go up or only go up very slowly, but given the obvious trend and the official projections, we should be prepared to avoid the potential risks and seize the opportunity while it still lasts.

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