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Brian Ricker

Interest Rates

Many of us would love to have a crystal ball telling us the future direction of interest rates. We know there are many factors affecting interest rates including economic growth, monetary policy, fiscal policy and the supply and demand for credit. With the cost of borrowing increasing over the past few years, I thought it would be a timely opportunity to discuss several current topics related to interest rates including:

  • Historic rate trends
  • The yield curve
  • Higher interest rates impact
  • Future regulatory changes

Historic rate trends – rising but historically low

From December 2008 to December 2015, the Federal Funds Rate remained unchanged at .25%. The Federal Funds Rate is the interest rate at which depository institutions lend their reserve balances to other depository institutions overnight. It is one of the most important interest rates in the U.S. economy, as it drives the Prime Lending Rate, an index used for many consumer loans. The Federal Open Mark Committee (FOMC), who meets eight times per year, determines the Federal Funds Rate.

The LIBOR index, a reference rate for many floating rate loans, was also at record lows during the same period and it remained relatively unchanged during the same 7-year period. LIBOR (London Interbank Offered Rate) is a benchmark rate changing daily, that leading global banks charge one another for short-term loans.

While variable rates were flat, fixed rates per the following chart, were migrating downward by nearly 300 bps from 2008 to 2015 (300 bps is the equivalent of 3%). There seemed to be no end for low rates and low volatility and it was evident these were unprecedented times. The low rate environment was due to a stagnant US general economy, low inflation and the need for a more expansionist monetary policy.

Today, we are experiencing a growing U.S. general economy, increasing interest rates and a more contractionary monetary policy. Since December 2015, the Federal Funds Rate has increased to 2.25% (as of this writing) with additional increases expected. The one-month LIBOR increased 2.0% with the 1-month index at 2.25% as of midOctober. The following chart is a representation of AgCredit fixed rates and it shows them increasing approximately 235 bps from 2012 until October 2018. From an eighteen-year history, rates are still low, and though increasing, remain well below the levels from the early 2000’s. We urge you to review how higher interest rates might impact your farm operation. 

Yield curves – normal, flat or inverted

Yield curves are a graph in which interest rates (yields) of fixed interest securities are plotted against the length of time they have to maturity. The curve shows the relation between the interest rate and the time to maturity. A normal yield curve is one where shorter-term instruments have a lower yield than long-term instruments of the same credit quality giving the yield curve an upward slope.

As the yield flattens, an inverted yield curve can result and longterm instruments have a lower yield than short-term instruments of the same credit quality. Though an inverted yield curve is rare, it is considered a predictor of an economic recession. As an example, when the two-year treasury rate is higher than the ten-year there is an inverted yield curve. As the following graph demonstrates, the last seven recessions had an inverted yield curve prior to the recession. Recently, the treasury yield curve has been receiving greater attention due to the curve flattening and moving to a higher potential for inversion.

Interest rate changes – impacts many financial decisions

The cost of capital affects many business decisions. With interest rates at unprecedented low levels for many years, it was easy to get used to this low cost of capital. The cost of capital refers to the opportunity cost of making a specific investment. It is the rate of return that could be earned by putting the same money into a different investment with similar risk. For example, when interest rates were at historic lows, the cost to carry assets was also low and it would help mask inefficiencies within the asset base of an operation. It may be wise to think about the cost of capital in regards to the timing issues with the sale of crops/ inventory, the purchase of inputs, carry in the grain market and capital purchases.

How much of an impact will higher interest rates have on land values? Though interest rates are still low from a historic perspective, if they continue to increase, a higher cost of capital in most cases would have a negative effect on land values.

Currently seventy-nine percent of all loans within our portfolio have fixed rates and they provide a welcomed hedge against higher interest rates. Unfortunately, fixed rates were not readily available to farm operations during the 1980’s farm crisis. Future fixed rate loans though, will carry a higher interest cost compared to a loan from a few short years ago.

Potential regulatory change - LIBOR index

The LIBOR (London Interbank Offered Rate) index has been the dominant reference rate for financial instruments, particularly floating rate loans. In July 2017 the regulatory agency supervising LIBOR announced it will phase out its support of LIBOR by the end of 2021. Banking regulators have been expressing concern about LIBOR over the past several years. The concern is related to a declining volume of borrowing to calculate the LIBOR rate. A possible alternative being researched is the Secured Overnight Financing Rate (SOFR). The Federal Reserve began publishing a SOFR index in April 2018. The SOFR is preferable to LIBOR because it is based on actual transactions and it will be a more actively traded market. The Farm Credit System is actively monitoring and participating in discussions about the possible phase-out of LIBOR as a benchmark for floating rate loans. It is expected LIBOR will continue to be in use through at least 2021. In the future you will hear more about LIBOR and SOFR as more information is learned. We would anticipate any future changes to borrowers to be seamless.

We anticipate 2018 to be another prosperous year at AgCredit. One of the unique benefits of being a member of AgCredit is to share in the association profits through the return of patronage. We have been fortunate to return on average 27.9% of accrued interest in cash over the past 4 years. We are looking forward to sharing details on our association patronage and financial results in early 2019. Until then we want to wish you and you and yours a Merry Christmas and a prosperous New Year!