Rates vs Reality: Why Higher Interest Rates Have Not Impacted the Economy Yet

Chart of the Month
Written By Jonathan M. Elliott, CPWA®, CRPC®, CDFA®, ChSNC®, CPFA™, RMA®

Photo Credit: Yohan Marion, Unsplash

The Federal Reserve has raised interest rates by over 5% since March 2022. It has been the fastest pace of tightening in decades, but data shows the economy has been resilient thus far. The U.S. economy grew at a 5.2% annualized pace in the third quarter, the fastest since Q4 2021, due to robust consumer spending, increased government spending, and companies restocking inventories. Companies continue to add jobs and increase wages in the labor market, and the current 3.7% unemployment rate is low compared to history. Construction spending rose +10.7% year-over-year in October despite higher financing costs, with activity increasing in both the public and private sectors.


Why are the Fed’s rate hikes having only a marginal economic impact?

The two charts below show a large gap between headline interest rates and the effective rate on existing debt. The first chart below shows the average 30-year fixed-rate mortgage was 7.62% at the end of September. However, the effective interest rate on all existing mortgage debt was only 3.74%, or nearly 4% below the headline mortgage rate. Figure 2 reveals a similar dynamic in the corporate bond segment. The yield-to-maturity on a broad high-yield corporate bond index currently sits at 8.4%, a proxy for what new high-yield borrowers would pay. However, the average coupon on the bonds within the index, which more accurately reflects borrowers’ actual interest rate, is only 6.1%, or 2.5% below the current high-yield borrowing rate.

US 30-Year Fixed-Rate Mortgage

US 30-year mortgage rates

US Corporate High-Yield Bonds

US corporate high yield bond interest rates

The two charts help to explain the Fed’s limited impact thus far. Many homeowners and companies took out fixed, low-interest-rate loans during the pandemic. While interest rates have increased significantly over the past 20 months, these borrowers’ monthly payments are unchanged, which means their financial situations and spending habits are mostly intact. The gap between headline interest rates and the effective rate on existing debt has shielded the economy from the immediate impact of the Fed’s rate hikes. However, this does not mean the economy will forever be immune to higher interest rates. The gap will likely narrow as mortgages and corporate bonds mature, and borrowers refinance at higher interest rates.

 

Important Disclosures
This material is provided for general and educational purposes only and is not investment advice. Your investments should correspond to your financial needs, goals, and risk tolerance. Please consult an investment professional before making any investment or financial decisions or purchasing any financial, securities, or investment-related service or product, including any investment product or service described in these materials.

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Jonathan M. Elliott, CPWA®, CRPC®, CDFA®, ChSNC®, CPFA™, RMA®

I am currently the Managing Partner for our independent investment advisory firm, Optima Capital Management. Together with my business partners, Todd Bendell CFP® and Clinton Steinhoff, we founded Optima Capital in 2019 as a forward-thinking wealth management firm that serves as an investment fiduciary and family office for high-net-worth individuals and families. In addition to being the Chief Compliance Officer, my role at Optima Capital is portfolio management. I have over 22 years of experience in managing investment strategies and portfolios. I specialize in using fundamental and technical analysis to build custom portfolios that utilize individual equities, bonds, and exchange-traded funds (ETFs). I began my financial services career with Merrill Lynch in 2003. At Merrill, I served in the leadership roles of Market Sales Manager and Senior Resident Director for the Scottsdale West Valley Market in Arizona. On Wall Street Magazine recognized me as one of the Top 100 Branch Managers in 2017. I am originally from Saginaw, Michigan, and a marketing graduate from the W.P. Carey School of Business at Arizona State University. I am a Certified Private Wealth Advisor® professional. The CPWA® certification program is an advanced credential created specifically for wealth managers who work with high net worth clients, focusing on the life cycle of wealth: accumulation, preservation, and distribution. In addition, I hold the following designations - Chartered Retirement Planning Counselor (CRPC®), Certified Divorce Financial Analyst (CDFA®), Certified Plan Fiduciary Advisor (CPFA), and Retirement Management Advisor (RMA®). In the community, I am a member of the Central Arizona Estate Planning Council (CAEPC) and serve as an alumni advisor and mentor to student organizations at Arizona State University. My interests include traveling, outdoors, fitness, leadership, entrepreneurship, minimalism, and computer science.

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