Up or Down?

by Patrick Flanagan

Most experts say short-term interest rates will be unchanged through 2014, but long-term rates are inching up.

When we look at interest rates indexes used by bankers in pricing loans we look at the short-term end of the spectrum and the long end. At the short end are Prime and LIBOR and at the long end the 10-year U.S. Treasury rate. Both sets of rates have been at or near historically low levels for so long that many in the borrowing community assume current rates are somehow normal, but that is certainly not the case. Where typically market factors have determined interest rates with periodic tweaks by the Federal Reserve, the current rate environment has been dictated by Federal Reserve policy in an effort to keep rates low and add liquidity while a struggling national economy recovers.

As seen in Chart 1 at right, Prime Rate and LIBOR, which usually fluctuate up and down over the months and years and which track the Fed Funds rate, hit their low points in January 2009 and have remained locked at that level for the past five years.

We typically do not see this "flat line" behavior in the market, but then we have been living in extraordinary times since the Credit Crisis hit where extraordinary measures were taken to avoid a depression. It is widely accepted that this condition is temporary and that rates will adjust upward once the Federal Reserve removes its policy accommodation, but the question remains about when that will occur.

At the long end, 10-year Treasury rates have continued to fluctuate but have done so at historically low levels, hitting bottom in mid-2012 before bouncing back to current albeit still-low levels. This recent trend of increases is the result of the Federal Reserve reducing (referred to as "tapering") its purchases of U.S. Treasuries. The level of purchases is announced on a periodic basis by the Federal Reserve and is kept secret until announced.

Even with the increases from the end of 2012, these rates are extremely low in a historical context.

So where will these rates go through the end of 2014 and forward? Most economists and Fed watchers assume that the short-term indices will be unchanged through the end of 2014 because the Federal Reserve still sees weak job growth/unemployment and slow price increases and does not want to impair the recovery of those metrics until they see sustained improvement. So don't look for any changes in Prime or LIBOR through the end of the year.

The long-term rates will continue to creep up as the Federal Reserve reduces its purchases, with most economists projecting the 10-Year Treasury rate to end 2014 at around 3.20 percent. The challenge here is that the Treasury market will shift from the certainties and predictability of Federal Reserve purchases to open market factors, meaning that yield rates will be determined by traditional supply and demand factors tempered against market risk rather than an orderly program of government purchases. If rates hit 3.2 percent by the end of the year, the ride will be bumpy along the way. Banks that use these indexes to price their loans will look at the possibility of upward movement and build future rate changes into current spreads. Look for wider spreads going forward when the market moves back to market factors rather than government support.

A final word about banks in general for 2014 and beyond: Community banks are of unquestioned value to local businesses for a host of reasons, and it is mostly these banks that have significant pricing challenges caused by regulatory requirements, both in terms of the costs to comply with myriad new regulations as well as evolving capital requirements. As go the health and stability of these community banks, so go the health and stability of the communities they serve, meaning that the communities must work with their banks to minimize the impact of these factors to ensure continued success for all stakeholders.

(Brian Andrews is assistant director of the Real Estate Research Institute at LSU's E. J. Ourso College of Business. His business is Andrews Commercial Real Estate Services, and he can be reached at [email protected].)