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When Will Interest Rates Go Down & What It Means for Investors

When will interest rates go down article

Agnes A. Gaddis

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In the world of finance, the year 2023 feels like a roller coaster ride, with interest rates soaring to breathtaking heights, reminiscent of the late 2000s, before the global financial crisis. The Federal Reserve’s seemingly unrelenting tightening measures have been led by a series of federal funds rate hikes — 11 increases within 12 meetings, to be precise — propelling the target range to a staggering 5.25-5.5 percent.

Be that as it may, savvy investors know that swift currents can bring a wealth of opportunities. In this river of high interest rates, finding a way to navigate toward success means adapting to the changing financial tides, exploiting the hidden gems, and overcoming the challenges that lie ahead.

The key to thriving in a rising interest rate investment scenario rests in understanding how high interest rates today impact the value of various asset classes, and consequently tweaking your investment strategies. Recognizing the potential advantages of sectors like real estate, particularly income-generating properties, can pave the way to success for informed investors. While some may argue that it’s wise to wait for central banks to lower interest rates again, the truth is that embracing alternative financing options now can lead to better deals.

So, it’s time to gear up and delve into the intricacies of the current interest rate landscape in the US. Join us as we explore the burning question: when will interest rates go down?

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Interest Rates and Their Impact on Investments

High interest rates, while beneficial in some respects, present hard-hitting challenges to businesses and individuals. With rising borrowing costs, the capacity for investment spending constricts like the walls of a shrinking room. It is worth noting that rising interest rates can potentially cause a recession.

However, just as every cloud has a silver lining, so does a high-interest-rate scenario. As investors, it’s crucial to carve out unique paths to capitalize on this situation. One such pathway is through the strategic choice of fixed-income securities with short durations. The reason: short-term bonds offer a buffer against interest rate risk, which long-term bonds lack.

As real estate investors, knowing how to perch on this wave of elevated rates can take you toward lucrative opportunities, fortifying your portfolio for the long run. Let’s now examine the intricacies of high interest rates and their impact on investments.

What High Interest Rates Mean

Interest rates are the Federal Reserve’s primary weapon against inflation. But how does raising interest rates affect inflation precisely? Inflation arises from robust consumer demand, and by increasing interest rates, the central bank aims to curb spending by making borrowing more expensive.

Higher interest rates lead to escalated borrowing costs, which in turn lowers disposable income and curb growth in consumer spending. As a result, inflationary pressures are alleviated, and the exchange rate appreciates. Furthermore, elevated interest rates translate to higher payments on credit cards and loans, discouraging people from borrowing and spending.

Consequently, those with existing loans are left with less disposable income due to increased interest payments, causing a decline in consumption across other sectors. It’s also worth noting that savings accounts that currently yield minimal returns become more lucrative in the face of rising interest rates.

How High Will Interest Rates Go?

Based on the latest projections from the Federal Reserve, interest rates may rise one more time this year. After raising their benchmark lending rate to the highest level in 22 years on July 26, 2023, it is clear that the Federal Reserve is vigilant about the prevailing inflation scenario despite its recent slowdown.

Despite the encouraging signs of inflation’s steady deceleration, officials maintain that inflation remains high and that the Fed’s focus on inflation risks is unwavering.

This recent hike by the Fed marks the 11th rate increase since it started its fight against inflation. This move came just a month after the central bank paused to evaluate the economic aftermath of the collapse of three regional banks.

While Fed officials are keeping the possibility of another hike on the table, should inflation prove more stubborn than anticipated, the timeline of this potential final hike remains uncertain.

Amid these circumstances, the investor community is optimistic about the cessation of rate hikes and the Fed’s ability to achieve a ‘soft landing’. A soft landing scenario is one where inflation reduces to the target 2% without a severe economic downturn. However, Fed Chairman Powell cautioned that attempts by central banks to slow the economy to curb inflation have historically resulted in softer labor conditions, suggesting that this is likely to be the outcome again.

Factors that influence interest rates

1. Credit supply and demand

The health of the credit market revolves around two key indicators: prevailing interest rates and investor demand. Additionally, the spread between interest rates on different types of bonds – Treasury, investment-grade, and junk – plays an instrumental role. It is within this complex and dynamic environment where credit supply and demand interact vigorously to shape the trajectory of interest rates.

When the need for money, or credit demand, intensifies, interest rates naturally rise, reflecting the market’s willingness to pay more for borrowed funds. On the contrary, softer demand for credit alleviates upward pressure on interest rates. The volume of accessible credit, or the credit supply, holds equal influence – a rise in credit supply casts a downward influence on interest rates, while a contracted supply does the opposite by pushing rates up.

Drilling down further into the drivers of credit supply, let’s examine how individual actions can ripple into broader market effects. For instance, opening a Certificate of Deposit introduces new capital into the banking system, which subsequently becomes available for lending purposes. The capacity for banks to lend more enhances credit availability to the economy. As this supply expands, the cost to borrow – denoted by interest rates – is inclined to decrease.

However, certain actions can constrict the readily available credit pool. An illustrative case is when borrowers decide to postpone their repayment obligations, such as deferring payment of the month’s credit card bill to a later date. This kind of action necessarily entails higher interest payments for the borrower but also works to limit credit available in the market. If this happens on a large enough scale, economy-wide interest rates will rise.

2. Inflation

Inflation and interest rates are closely linked, as they both impact the economy and the value of money. When inflation is high, interest rates tend to rise, and when inflation is low, interest rates fall. Here’s how this relationship works:

When inflation is high, lenders demand higher interest rates to compensate for the decrease in the purchasing power of the money they receive in the future. This is because if inflation is high, the value of the money borrowers owe is also decreasing. To account for this, lenders charge higher interest rates to make sure they can earn a decent return on their investment.

For example, if inflation is 3%, and you borrow $100 today, next year you will owe $103+. So, the lender needs to charge a higher interest rate to account for the loss of purchasing power.

The Federal Reserve, as the primary monetary authority in the United States, leverages interest rates as a key tool to control rampant inflation. When inflation overshoots a comfortable level, the Federal Reserve responds by escalating interest rates to decelerate the economy and curtail inflation. Conversely, in periods of low inflation, the Federal Reserve takes the opposite approach by lowering interest rates. This acts as an economic stimulus, encouraging spending and investment, which fosters an uptick in inflation.

3. Economic growth

Economic growth holds substantial power in manipulating interest rates within the larger running gears of an economy. One way it exerts this influence is through elevating the potential for returns on investment — which leads to increased investment demand. Key index funds and securities perform better in a growing economy, offering attractive incentives for investors. This leads to financial behavior that brings about an upward tilt in real interest rates.

Moreover, economic expansion increases the earning potential of households. In the face of prospective growth, consumers are motivated to spend more on consumption and goods at the expense of savings. Less saving and more investing due to economic growth culminates in a demand-supply shift that ushers in higher real interest rates.

4. Monetary policy

A government’s strive for economic equilibrium, as well as its active participation in the financial markets, shape the course for interest rates.

A fiscal deficit arises when government spending exceeds its revenue. The government, in turn, seeks to bridge this gap by resorting to borrowing. Given the government’s position as the largest borrower in an economy, the volume of its borrowing informs the demand for money. This, in turn, adds weight to the scales tipping interest rates.

The federal funds rate – the rate charged for extremely short-term interbank loans – paints the backdrop for the interest rate that banks impose on their lending capital. Any variation in the federal funds rate is thus reflected across other short-term lending rates within the economy. Central banks like the Federal Reserve shape and channel these rates using “open market transactions”.
Open market transactions – the buying and selling of previously issued U.S. securities – constitute a core instrument employed by the Federal Reserve in governing interest rates.

When the Fed buys more securities, an inflow of money streams into the banks, making more funds available for lending. This surplus of funds versus borrower demand leads to a decrease in interest rates. Conversely, the sale of securities by the Fed results in a drain of money from banks. This squeeze in money supply pushes interest rates upwards as less money remains available for lending.

5. Global interest rates

Fluctuations in interest rates on a global scale directly feed into the shifting financial landscape in the United States. The following analysis spotlights the chain reactions sparked by the ‘great tightening’ that began in 2021 and its influence on the US market:

Beginning in the spring of 2021, central banks across Latin America and Central Europe kicked off an upward adjustment of interest rates to stabilize their fluctuating currencies and beat back rising inflation. By year-end, wealthy countries like Norway and South Korea had joined the cause, with almost every major economy following suit over the course of the year.

The global increase in interest rates, engineered to quell the largest inflation rampant in four decades, imposed substantial strains on banks in the United States and Europe. Despite the general perception that rate hikes favor depositors, the financial aftermath of this recent wave of tightening monetary policy was adversely different.

Significantly, these shifts precipitated losses for banks on their bond holdings, including those traditionally considered ‘safe’, like US Treasuries. The cumulative financial stress resulted in the collapse of some banks. Given the integrated financial ecosystem, changes in global interest rates therefore have tangible effects on domestic rates in the US.

How changes in interest rates affect various types of investments

1. Stocks

The Federal Reserve Board (Fed) controls the U.S. federal funds rate. This rate is the benchmark for interbank loans and is pivotal to the health of the wider economy. Although changes typically require 12 months to permeate through the economy at large, the stock market often responds immediately.

With interest rate hikes, the cost of raising capital for companies also increases. Higher rates on the bonds they issue means more expense for these businesses. Therefore, capital becomes less accessible, which can stunt both immediate earnings and future growth potential.

As a consequence, companies often revise their profit forecasts downward when rates rise. This projection impacts their stock value, making their stocks possibly less attractive to investors. The inverse is also true: lower interest rates often lead to upward revisions in profit forecasts, which can boost stock prices.

2. Bonds

Offering consistent interest payments over their lifespan, fixed rate bonds—available in various forms such as Treasury, corporate, municipal bonds, or certificates of deposit (CD)—are a popular choice for investors seeking guaranteed returns over a specified term.

Fixed rate bonds are at risk of interest rate fluctuations—the prospect of rising bond interest rates devaluing existing bonds. For instance, if an investor holds a bond with a 5% fixed rate and market rates surge to 7%, new bonds are issued at this higher rate, rendering the original investment less profitable.

This inverse relationship between bond prices and interest rates implies that the value of an investor’s bond drops as the market rate rises. Should the investor wish to sell their 5% bond to invest in the new 7% bonds, this would likely entail selling at a loss due to the bond’s decreased market value. Bonds with longer terms are more susceptible to these risks.

3. Real Estate

Interest rates play a significant role in real estate market trends and dynamics. As interest rates swing, they can greatly shape the cost of owning a home and consequently the attractiveness of real estate investments.

When interest rates rise, the cost to finance a home increases accordingly. This heightened financial obligation reduces the overall demand for housing, as prospective buyers are dissuaded by the more substantial outlay. The consequent reduction in demand tends to trigger a drop in home prices, as market forces react to diminished buyer interest.

On the other hand, when interest rates decrease, the overall cost of purchasing a home becomes more affordable. This catalyzes a surge in housing demand, as more buyers take advantage of the more favorable financing conditions. As this demand intensifies, it exerts upward pressure on home prices, leading to a robust and thriving housing market.

For real estate investors, periods of high or escalating interest rates can raise the risk profile of new deals significantly. The cost of capital becomes more unpredictable and credit spreads widen as lenders strive to contextualize the impact of higher interest rates on debt coverage and collateral value.

The fallout from these dynamics was strikingly evident last year when mortgage rates doubled, jumping from the mid-3% range to the mid-6% range. In a bid to shield themselves from risk, lenders have lowered loan proceeds, necessitating larger equity contributions from borrowers and subsequently reducing leveraged cash on cash returns.

Staying ahead of the curve in today’s volatile financial landscape necessitates a keen awareness of future trends, particularly when it comes to interest rates. Knowledge of these trends can significantly influence your investment strategies, real estate decisions, and other financial undertakings. So, what does the future hold for interest rates? Here is a look at the current trends and expert predictions for the near term and the next 5 years.

Interest Rates Today - Are they low or high compared to historical norms?

With the central bank’s 11th increase in rates since 2022, its policy rate has jumped from zero to 5.25%, prompting a sharp rise in mortgage rates. Historical data reveals that throughout most of 2020 and 2021, mortgage rates were at an all-time low. However, these rates climbed consistently in 2022 as the Federal Reserve embarked upon an aggressive series of hikes.

As of August 16, 2023, Bankrate’s data highlights a current average 30-year fixed mortgage interest rate of 7.55%, indicating an 18 basis point increase over the past week. For those refinancing, the 30-year fixed refinance interest rate is 7.71%, rising 28 basis points in a week. In addition, the national average 15-year refinance interest rate is 6.91%, up 14 basis points from the previous week.

Bankrate Fixed Rate Mortgages

Image Source: Bankrate

But when will mortgage rates go down? According to Neel Kashkari, president of the Federal Reserve Bank of Minneapolis, the benchmark interest rate—currently at its highest since 2001—could remain at least at this level throughout the year and beyond. Kashkari claims that “we are a long way away from cutting rates.” This perspective is informed by the current Consumer Price Index, which, as of July, showed a 3.2% annual increase—less than the 9.1% inflation rate of June 2022 but still higher than the 2% target set by the Fed.

Kashkari suggests that at some point, the Fed will shift its focus from battling inflation to lowering interest rates. However, this change could be far in the future, possibly occurring “sometime next year” or later, depending on incoming data.

Investors seeking success amid shifting policies can fortify their approach by maintaining a diversified portfolio, owning assets that outpace inflation, engaging in active portfolio management, and capitalizing on the interest rate environment.

Interest Rate Forecast for 2023 and 2024

Fannie Mae’s prediction

Fannie Mae forecasts a modest economic contraction starting in the second half of 2023. For Q3 2023, Fannie Mae believes that the average 30-year fixed mortgage rate will settle at 6.8%. They further project a Q4 2023 average rate of 6.6% for the same mortgage type, revealing a somewhat negative outlook as their earlier forecast in May 2023 for Q4 was 6%.

Fannie Mae Housing Forecast

Looking forward, Fannie Mae expects marginal rate declines. They predict a dip to 6.4% in Q1 2024, falling further to 6.2% in Q2 2024.

For the latter half of 2024, Fannie Mae’s data suggest average 30-year fixed mortgage rates of 6.0% and 5.9% for Q3 and Q4, respectively.

In tandem with the interest rate predictions, Fannie Mae envisions a rise in single-family mortgage origination amounts—an increase from $1.6 trillion in 2023 to $1.9 trillion in 2024.

The MBA’s forecast

The MBA’s Mortgage Finance Forecast takes a positive stance. By the end of 2023, the MBA projects that 30-year mortgage rates will descend to 5.9%. Furthermore, 2024 is expected to see continued improvement, with rates dipping below the 5% threshold in the fourth quarter.
According to the MBA, rates for 30-year fixed mortgages will follow a steady downward trend in 2024. The first quarter’s predictions round out at 5.7%, with subsequent quarters seeing rates of 5.5% and 5.2%. By the close of 2024, the association projects rates of 4.9%.

MBA Mortgage Finance Forecast July 2023

Image Source: Mortgage Bankers Association

On the mortgage originations front, the MBA’s projections are equally upbeat. Total mortgage origination amounts are expected to rise from $1.75 trillion in 2023 to $2.18 trillion in 2024. By 2025, origination amounts are expected to exceed 2022 numbers.

The National Association of Realtors’ forecast

Recent estimations from the NAR, in conjunction with Freddie Mac, predict an average rate of 6.5% for the 30-year fixed mortgage in 2023. While in 2024, these rates are anticipated to dip to around 6%.

Freddie Mac & Nar Mortgage Rate Forecast

Image Source: National Association of Realtors

Nadia Evangelou, NAR’s Senior Economist and Director of Real Estate Research, has identified three potential rate scenarios for the remainder of 2023. These situations are primarily contingent upon the Federal Reserve’s actions in response to inflation:

Scenario 1 – Persistently High Inflation: If inflation remains high, the Fed will continue to hike interest rates. This trend could ultimately lead to mortgage rates escalating, potentially reaching 8.5%.

Scenario 2 – Inflation Gradually Decelerating: In this scenario, the Consumer Price Index shows greater responsiveness to the Fed’s rate hikes, causing a steady abatement of inflation. Consequently, mortgage rates would likely stabilize near 7% to 7.5% for 2023.
Scenario 3 – Economic Recession: In the third situation, the Fed aggressively raises rates to curb inflation, inadvertently pushing the economy into recession. This outcome might prompt rates to drop to approximately 5%.

Trading Economics

Trading Economics, an economic forecasting platform, projects that interest rates in the United States will stand at 5.50% by the end of the current quarter. The economic models developed by Trading Economics indicate that the United States Fed Funds Rate will experience a gradual decline in the coming years. In 2024, the funds rate is expected to hover around 4.75%, dropping further to 3.50% in 2025.

ING Think

ING Think, an economic and financial analysis firm, expects the Federal Reserve (Fed) policy rate to hit 5.5% in the third quarter of 2023, before reducing to 5% in the first quarter of 2024. From there, ING Think projects a continued decline in policy interest rates, with the following predictions:

  • Second quarter 2024: 4%
  • Third quarter 2024: 3.5%
  • Fourth quarter 2024: 3%

Image Source: ING

It’s imperative to note that all these predictions are based on certain assumptions and are subject to change based on various economic factors.

Projected Interest Rates in 5 Years

Now we will look at two data sources to see what they project for interest rates in the next 5 years.

LongForecast

LongForecast projects a rise in average mortgage interest rates throughout 2023 — from 6.96% (6.75% low – 7.17% high) in August to 7.64% (7.3% low – 7.87% high) by December.
30 Year Mortgage Rate Predictions longforecast

Image Source: LongForecast

The company anticipates volatility in the first half of 2024. They expect the rate to start at 7.64% (January), peak at 7.96% (April), then drop to 7.07% by July. Rates are projected to rise again to 7.38% in August, followed by a consistent deceleration from September.

LongForecast predicts a slowdown in rates from 6.94% in September 2024 to 4.58% in August 2025. Expect fluctuations between 4% and 5% from August 2025 through August 2026. Rates are expected to stabilize at 4.57% by August 2026.

Beyond August 2026, another deceleration phase commences. The average 30-year fixed mortgage rate is forecast to fall to 3.47% by August 2027.

Morningstar

Morningstar forecasts a year-end 2023 fed-funds rate of 5.25%. They also expect the 30-year mortgage rate to average 6.5% during the same year. According to Morningstar, the 10-year Treasury yield is likely to land at an average of 3.5% in 2023, eventually falling to 2.5% in 2025. The 30-year fixed mortgage rate will average 5% in 2024, driven by shifts in the marketplace and anticipated adjustments to the U.S. Federal Reserve’s approach to monetary policy.

Image Source: MorningStar

As the U.S. Federal Reserve shifts to easing monetary policy, Morningstar projects that the fed-funds rate will drop below 2.00% by mid-2025. In tandem, the 30-year mortgage rate should fall to an average of 4% for both 2025 and 2026, signaling potential opportunities for investors.
MorningStar Fed Fund Rate Expectations

Image SourceMorningStar

Morningstar anticipates that the inflation rate will average 1.8% between 2024 and 2027, undershooting the initial expectations of the Federal Reserve. Alongside this prediction, they also forecast a cumulative 4% more real GDP growth through 2027 than consensus estimates.

What a Reduction in Interest Rates Means for Real Estate Investors

So when will interest rates go down? With some forecasts being more optimistic than others, investors have to prepare for both high and low interest rate scenarios. But a general consensus amongst experts is that interest rates should start easing by next year. So what will reduced interest rates mean for investors?

Increased demand for property

Low interest rates make borrowing cheaper. This tends to galvanize spending and investment, sparking a surge in aggregate demand (AD) and driving economic growth.

In 2020, the rational impact of low interest rates was explicitly evident in the housing market. These attractive rates decreased the cost of borrowing for potential homeowners interested in financing a property purchase or construction, inevitably leading to an uptick in housing demand.

Conversely, as evident in 2023, rising interest rates put a damper on property demand. Year-over-year home sales fell in many markets due to increased borrowing costs. Simultaneously, the hike in interest rates alongside decreasing home prices decelerated construction, consequentially curtailing the supply increment in the housing market. When interest rates take a dip, builder sentiment gets a boost.

Rise in property values

2020 and 2021 witnessed record-breaking growth in median home list prices — driven by low mortgage rates, limited inventory, and an influx of eager buyers. So, what would happen if interest rates were to decrease now?

A drop in interest rates would coax many new buyers to enter the market. Given the persistent scarcity of property supply in many regions, this steep surge in demand would spur the growth of property values as competition for available listings intensifies. In such cases, reduced interest rates serve as a trigger for rising property values.

Lower Cap Rates

When interest rates are reduced, it means that the cost of borrowing money is lower. This makes it easier for investors and home buyers to borrow money to purchase properties. As a result, the demand for properties tends to increase, which can drive up property prices.

Higher property prices lead to lower cap rates. The cap rate is calculated by dividing the property’s net operating income (NOI) by its purchase price. When the purchase price increases, the cap rate decreases, as the same amount of net operating income is being divided by a larger number.

For example, let’s say a property has a NOI of $100,000 and a purchase price of $1,000,000. The cap rate would be 10% ($100,000 / $1,000,000). If interest rates are reduced and the purchase price increases to $1,500,000, the cap rate would decrease to 6.67% ($100,000 / $1,500,000).

So, lower interest rates can lead to lower cap rates because they increase demand for properties, driving up prices and reducing the potential return on investment. Conversely, higher interest rates could lead to higher cap rates. Generally, a high cap rate suggests higher returns but higher risk, while a low cap rate reflects less risk but lower returns.

Decreased monthly mortgage payments

When interest rates are reduced, borrowers can access cheaper credit, which leads to lower monthly mortgage payments.

To illustrate, at a 4% interest rate, a $250,000 mortgage would cost $1,185 per month. If interest rates are reduced to 3%, the monthly payment for the same $250,000 mortgage would decrease to $1,074 per month. That’s a savings of $111 per month or $1332 per year.

The effect of lower interest rates on monthly mortgage payments is even greater for larger loans. For example, a $1,000,000 mortgage at 4% interest would cost $4,543 per month. At 3%, the monthly payment would decrease to $4,096 per month, a savings of $447 per month or $5,364 per year.

So, reduced interest rates can lead to a significant decrease in monthly mortgage payments, leaving investors with more cash flow to invest in other opportunities or to cover other expenses.

Would you like more mortgage rate forecasts? Check out our 5-year predictions for the US real estate market.

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