Think High Rates Are Bad? It’s A Misperception Of Our Time

Forbes Finance Council POST - (Originally published on August 29, 2024 at https://www.forbes.com/councils/forbesfinancecouncil/2024/08/29/think-high-rates-are-bad-its-a-misperception-of-our-time/)

All too often the discussion of whether interest rates are too high or too low leads to unsatisfactory conclusions. The Federal Reserve fixates its myriad resources on something called the “neutral rate” or “r*” to best navigate the economic cycle. Banks are concerned about the federal funds rate since it’s the rate they borrow and lend their excess reserves to each other overnight. Most Americans care a lot about their mortgage rate because it’s the financing mechanism for their household’s largest asset. But there’s one thing that all these rates have in common—the fallacy of recency bias.

Recency bias emphasizes the events or conditions closest to memory as being more important than those experiences further in the past. It’s a highly punitive behavioral response, often leading to less beneficial decision making in the short term. An easy example of this bias is selling stock positions in bear markets, while buying euphorically in bull markets. Neither action is warranted by the recent events alone. Appreciating the bigger picture that impacts the conditions throughout market cycles is a far better (and arguably) more profitable approach.

An Illustration Using Mortgage Rates

Mortgage rates are specifically meant to be a financing tool for long-term real estate purchases. Looking back at mortgage rates over the past 30 years illustrates just how significant the oscillation has been (you can view our firm’s research on the subject, which illustrates the data discussed in this article). In November 1994, 30-year mortgage rates were at 9.25%. In January 2021, mortgage rates stood at 2.65%. That’s a 660-basis point difference. You might logically assume that higher rates in the past corresponded to much lower mortgage originations. But you would be wrong.

In fact, the only other time mortgage originations exceeded $1 trillion per quarter was during two quarters of 2003. This occurred at a time when mortgage rates were around 6%. Fast forward a couple of decades, for a few quarters from late-2020 to mid-2021, originations held above $1 trillion per quarter while mortgage rates bounced around multi-generational lows around 2.75%.

And by the way, when mortgage rates were around 6% in 2003, the 10-year U.S. Treasury rate was around 4%. This is more or less where we find ourselves today. Anyone who tells you that “this time is different” hasn’t observed (or understood) the cycles of money flowing from one area to another throughout economic history.

An Economy In Transition

All capital markets go up (a lot) and then down (a lot) based on the never-ending migration of capital in search of optimal risk-adjusted returns. High interest rates are not a bad thing for an economy. Low interest rates are not (necessarily) a good thing for an economy. Instead, keep in mind that all rates are always in transition, seeking equilibrium within the broader capital markets and more specifically within money markets. This is usually accompanied by high volatility in capital markets.

Financial advisors and investors should understand how their portfolios are currently positioned to deal with a seismic secular change in our interest rate environment of late. During these types of major economic transitions, it’s perfectly normal for capital and asset values to come under significant pressure. Those who prevail on the other side of these secular shifts are typically more concerned about maintaining cash flows and profit margins, while leaving growth expectations to the next phase of the cycle.

The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.