Don't Count On Higher Interest Rates Quite Yet

For the past two years most of the discussion about interest rates has centered on when the Federal Reserve will start to raise interest rates. As the unemployment rate has dropped over the past year and economic growth has finally accelerated, people have been moving forward their forecasts of when the Fed will begin pushing rates up. Recently, the only debate has been about exactly which month the rate increases will begin. Yet, investors and borrowers should be cautious about assuming that interest rates are certain to rise.

Two factors are complicating the previous certainty about interest rates climbing in 2015. First, we have the sudden plunge in several commodity prices, led by oil but also including such industrial commodities as copper. Second, market participants should remember that the Fed only controls some interest rates and if inflation expectations are low enough, many rates might stay low regardless of Fed action.

Oil prices have been cut in half by a combination of increased U.S. production, high and sustained worldwide production even as prices fall (thank you, Saudi Arabia), a softening in world oil demand, and a growing fear of further weakness in demand. Copper prices have been on a similar plunge. In fact, as recently reported by Bloomberg, commodity prices have now reached a 12 year low, meaning they are even lower than in the depths of the recession.

Meanwhile, the weak retail sales in December, the continued failure of the Fed's desired inflation to appear, and worries about economic weakness in the rest of the world have U.S. interest rates declining. The traditional benchmark 30-year bond yield recently broke through 2.4 percent to an all-time record low while the 10-year yield fell below 1.8 percent.

If everyone was still convinced rates were on their way up, it would be very hard to push them down this close to a looming rise in rates. After all, everyone buying just before rates reversed direction would face potentially steep capital losses. Thus, the recent drops in Treasury yields (especially in the long bond) suggests some people do not see an interest rate increase as a done deal.

Importantly, returning to my second point, many other interest rates are harder for the Fed to control than Treasuries. Mortgage rates, car loans, and commercial loans are all only indirectly affected by the Fed. Expectations on default rates, inflation, and costs of funds all play important roles in setting these market rates and while the Fed can push on inflation and cost of funds, it clearly does not have full control of those measures or we would have far more inflation than is apparent.

In fact, 30 year mortgage rates have been trending generally downward over the last 12-18 months (zig-zagging along the way), with that drop accelerating over the past six months. If all those mortgage originators and funders were sure rates were about to rise, they would already have raised their rates.

When rates fall, borrowers refinance their mortgages and when rates rise, they hold onto their mortgages; thus, lenders know that when rates rise they risk being stuck for a long time with below-market returns. That gives them a powerful incentive to raise their rates before the Fed begins to move; yet, the data shows no sign on such a preemptive rise in mortgage rates.

Car loans and personal consumer loans also display a slow and steady downward trend in the average rates over the past year. Combined with the pattern of mortgage rates, the picture of rates in the marketplace seems clear. While all the experts expressing opinions (including those at the Fed who actually make the decision) are convinced that the Fed is about to start increasing interest rates, those who lend money do not seem to be acting as if they are worried about either a higher cost of funds or increased inflation. Lenders continue to be quite willing to lend money for rather long terms at historically very low rates.

For all the consensus that rates will move upward this year, the credit markets seem to be taking an opposite view. Mortgage, personal, and auto loans all show declining interest rates. Lenders appear to be betting against both inflation and higher interest rates. It is always dangerous to fight the Fed, and in this case the Fed has been telling anybody who wants to listen that they plan to start raising rates sometime in 2015.

Yet, taking a simple look at the credit markets suggests all the experts debating the precise timing of the beginning of the increase in interest rate may be wrong. At a minimum, the consensus on higher rates is not as unanimous as many people are making it sound.