Economic Up Tempo May Prompt Rate Ratchet

Rising wages, employment may be greeted by rate hikes as Fed works to direct economic harmony.
Kevin Heal

A couple weeks ago it looked like U.S. Treasury rates were heading lower. Yields are higher but still lower than we started the new year. European rates were heading into negative territory (meaning that you would pay the German government to keep your money).

Oil prices were gurgling lower toward $40 a barrel but have since recovered to around $50 a barrel. Still, it’s nice to have a couple extra bucks in the mobile wallet after filling up. And that inspires me to set the rest of this outlook to song.

Smokin Boston

Then last week, the monthly employment numbers were released. The Fed uses these numbers to shape policy. The Fed wants the unemployment rate below 6% and inflation somewhere around 2%.

The jobless rate has been below that 6% target for quite a while. It actually rose to 5.7% this month from the previous 5.6% due to the fact that a number of people have put themselves back in the pie of looking for work.

Wages also posted gains so not only are more people working but they’re actually starting to make a little more money. Job growth was greater than expected and the job gains may prompt the Fed to raise rates sooner rather than later. Perhaps this summer instead of this fall.

Black Gold, Texas TeaThe Beverly Hillbillies

One caveat to the robust job numbers is the yet-to-be seen effect on jobs related to the oil industry. The effects will be seen in the coming months as states that are reliant on the industry (think Texas, Louisiana, North Dakota, etc.) begin to see layoffs and ripple effects on the local economies.

Why Should I Care? The Who

If the Fed finally decides to raise rates how would this affect financial institutions? And more importantly, ME? Everything that a financial institution does is related to interest rates. Mortgage rates, auto loans, and consumer loans will all be affected. Anything that has a variable rate will be higher.

For example take a look at a typical ARM (Adjustable Rate Mortgage) 5/1. For the first five years the rate is fixed at a certain percentage. Let’s assume that when the mortgage was originated the rate was 3% for the first five years. After the first five years it then will adjust based on a certain index.

The most common index used today is 1 Month LIBOR. LIBOR stands for London Interbank Offered Rate. Similar to the Fed Funds Rate, this is the international rate in U.S. dollars at which banks lend to each other. It’s currently at .15%.

Most ARMs use a formula of 1 Month LIBOR + 2.75% when it’s time to adjust the mortgage. It will then carry that rate for one year and adjust every year after hence the term 5/1.

So let’s say you took out a 5/1 mortgage for $300,000 in January 2011. It will be fixed for the first five years so it won’t change until January 2016. ;The monthly payment would be $1,265. So as long as LIBOR stays at .25% or lower you’re a happy camper (2.75% + .25%=3%).

But what happens to the mortgage payment if LIBOR rises to, say, 1% by January 2016? So based on the formula the new rate on the mortgage would be 1% + 2.75%=3.75%. In five years you would have paid down about $34,000 in principal so the mortgage amount is down to $266,000. Just to give you a bit of indigestion, you would also have paid about $42,000 in interest.

Now you have 25 years left on a mortgage amount of $266,000 at 3.75%. The monthly payment just jumped from $1,265 to $1,367, costing you $102 a month more.

So as you can see that by raising rates the Fed can control the overall growth rate of the economy. The goal is to have wages grow slightly higher than the inflation rate. That way there’s more real money in your virtual wallet.

It’s a balancing act to stimulate growth in the economy without having too much inflation. And it’s enough to make someone at least an economist break out into song.

Kevin Heal is vice president of Callahan Financial Services ( He has more than 25 years of sales and trading experience with both large investment banks and regional broker-dealers.

February 6, 2015

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