Kiplinger's Interest Rates Outlook: Long-Term Rates to Stay Soft

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Long-term interest rates will likely stay below 4% this year, trending down as the economy slows and as the inflation rate comes down. Bond traders were cheered on Jan. 6 by the Institute for Supply Management’s report of a slowdown in the services sector, and by a drop in wage growth in the Bureau of Labor Statistics’ monthly jobs report. Wage growth is a key indicator of future inflation that the Federal Reserve is focused on right now. 

Short-term rates are still headed up, however, as the Federal Reserve is expected to make two to three more quarter-point hikes in the first half of this year. The relationship between long and short rates, called the yield curve, will invert even more. Some economists view yield curve inversion as a strong indicator of a future recession. 

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The Federal Reserve raised its short-term interest rate by a half-percentage point on Dec. 14, an easing from the Fed’s previous rate hikes of three-quarters of a point, but Fed Chair Jerome Powell was careful to say that more rate hikes are coming in 2023. He said that the main point of discussion among policy committee members was how high the Fed might need to raise rates in total and how long to hold them there, not the size of individual hikes at future policy meetings.  

The financial markets had hoped that the Fed might be willing to reduce rates in 2023 if the economy falls into recession, but Powell was not willing to discuss that possibility yet. Instead, he pointed to a still-tight labor market and strong momentum in services inflation and said that the committee members wouldn’t reduce rates until they were confident that inflation was coming down to their target level of 2%. Powell has warned against easing restrictive monetary policy too early. In his view, there is a real danger that a period of prolonged inflation could induce businesses and workers to automatically add a certain future inflation rate into their wage and price expectations. That mentality would stoke price increases in a self-perpetuating cycle, which would lengthen the time needed for higher interest rates to bring down inflation. Better to slow the economy enough with rate hikes to bring down inflation right away before this can happen, he argues.

Other short-term interest rates will rise along with the federal funds rate. Rates on home equity lines of credit are typically connected to the fed funds rate and move in lock-step with it. Rates on short-term consumer loans such as auto loans will also be affected. Rates to finance new cars are around 6% for buyers with good credit, and 9% for used-car buyers.

Mortgage rates will likely ease further. 30-year fixed-rate loans are around 6.4%, after peaking at 7.1% in early November, while 15-year fixed-rate loans are around 5.7%. Mortgage rates are reacting to the recent decline in the 10-year Treasury yield, though they are still about a full percentage point higher in relation to the 10-year Treasury than would normally be expected. Mortgage rates tend to stay higher for longer when inflation is high, whereas Treasury rates tend to be more sensitive to signs of economic slowing. 

Corporate high-yield bond rates have also peaked for the moment. AAA bonds are yielding 4.6%, BBB bonds, 5.7%, and CCC-rated bond yields are at 15.4%.  

Source: Federal Reserve Open Market Committee (opens in new tab)