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Inflation and interest rates


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This is a subject that's been on my mind. The Fed sure seems to have screwed this up. They are sooooo far behind. But that's water under the bridge. I just keep thinking about how long the high inflation is going to last especially if the Fed starts pushing rates up 50 bps every 6 weeks for a few quarters. This is going to really test the economy and the markets. You have rising prices on everything and now the cost of debt is really going to ratchet up. Seems like we're on a collision course for a significant slowdown. Consumers are going to be under a lot of pressure. Will demand wane and inflation ease? Or will inflation stay hot because of all the supply chain problems, tight labor market, etc.?

 

I also keep wondering if long-term interest rates are going to stay relatively anchored. Yields have moved up mostly in the 1-5 year part of the curve. Will we see a big jump in the 10-30 year segment? Or does the market think think we're going to bust and revert to pre-COVID economic trend? 

 

It seems like a crazy set-up with the Fed getting very aggressive with the backdrop of stock and real estate prices that have surged in recent years; plus bond yields that are still extremely low. Looks like some extremely choppy waters lie ahead. 

 

Just a bunch of random thoughts.

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Not an expert here, but could be by Central bank design. Monetary easing stoking inflation and helping reduce debt loads.

 

Likely unanticipated was the Russian - Ukraine invasion causing oil to spike which is driving inflation across the board much higher.

 

Challenge will be getting people back to work post COVID and filling all the job vacancies.  Unless that happens, supply chain issues can remain keeping inflation high.  

 

Recession risk is also high.

 

Imo, it will be difficult to get people to go back to work, at any pay.  

Edited by ICUMD
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I don't see the connection between consumer demand and hyperinflation. If anything, demand increases.

I think Erdogan is quite right. Higher rates just increases inflation, gallops even faster. You have to pay more on your debt, you charge more for everything.

Financial repression (read: theft of capital) is actually the government's unspoken policy choice. There was a paper that it is either inflation or default and nobody is gonna default overtly so they default covertly via inflation higher than rates for a relatively long period of time.

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Most of the inflation is coming from unprecedented fiscal stimulus, supply chain issues, labour market tightness and commodity prices. Some of those pressures will ease over the next year or two as the fiscal stimulus wears off and supply chain eases and labour market participation increases and there is some kind of supply response to higher commodity prices. 

 

Even if the Fed does ramp up interest rates by 50 bps every meeting we are still way way way below the neutral rate of interest let alone an interest level sufficient to push down inflation or cause a recession even with all the debt floating around in the economy. 

 

So I think the plan is financial repression plus look as if they are doing something to try and keep a lid on inflation expectations while waiting for inflationary pressures to ease naturally. 

 

 

 

 

 

 

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I have been thinking about this a lot too. What I want to understand is how much interest charge can the US debt tolerate. right now the US debt is 30Trillion, revenue is 4 Tril per year and interest payments is 430 B. So revenue is about 9x interest payments, and interest payments are at 1.7% on avg.  So the how much more in interest can the government take? double the 1.7% interest rate? triple?  I keep hearing the fed funds rate will rise to 2-3%, but how does that translate to 1-5 yr treasuries?

 

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2 hours ago, scorpioncapital said:

I don't see the connection between consumer demand and hyperinflation. If anything, demand increases.

I think Erdogan is quite right. Higher rates just increases inflation, gallops even faster. You have to pay more on your debt, you charge more for everything.

Financial repression (read: theft of capital) is actually the government's unspoken policy choice. There was a paper that it is either inflation or default and nobody is gonna default overtly so they default covertly via inflation higher than rates for a relatively long period of time.

 

With respect to demand and inflation, my thinking is demand for discretionary goods and services would wane as consumers burn more income on necessities and debt service. Likewise, if rising rates push asset prices down, the equity on a consumer's balance sheet shrinks which means less to spend or borrow against. These are the things running through my mind as I try to gauge how long-lasting inflation will be. But it seems really complicated because the inflation clearly also is related to the pandemic supply chain problems and tight labor force. And it's weird that long rates are still so low despite the raging inflation. It's quite the puzzle. 

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3 hours ago, ICUMD said:

Not an expert here, but could be by Central bank design. Monetary easing stoking inflation and helping reduce debt loads.

 

Who gets screwed over if everyone pays back their loans with worthless dollars?  My guess is "banks".  I also guess that banks would resist such a plan.  According to [1], banks are the shareholders of the twelve federal reserve banks -- so I imagine that "banks" have influence over the central bank.

 

All guesses... I'd like to know how it all really works.

 

[1] https://www.federalreserveeducation.org/about-the-fed/structure-and-functions

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When the inflation genie was back in the bottle the Fed has had some serious mission creep with the emphasis on full employment and desire to prop up the stock market to achieve positive wealth effects. But I do not think it has quite got to the point where it is actively trying to stoke inflation. 

 

The average inflation targeting framework was basically buying them some time to accommodate higher inflation post pandemic but clearly now requires decisive action. And there is now political pressure to get inflation under control and a serious credibility problem if the Fed isn't seen to be taking action.  

 

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Perhaps it depends on how much of a conspiracy theorist one is.   

 

The devils advocate would say:

In the past 10-15 years,  the most wealthy have been advantaged by being able to leverage their assets with low interest loans and avoid taxes in many instances.  Inflation will allow them to pay off these loans with cheaper dollars. Maybe the same folks who run the monetary system?

 

On the other hand,

Perhaps Inflation is just an unintended consequence of necessary monetary easing during the pandemic,  reaction to the sub prime mortgage crisis, supply chain issues and now the Russian Ukraine war and price of oil. 

 

Regardless, I think sticking to the basic tenet of buying quality businesses will help navigate these times. 

 

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Inflation is a product of the human desire to get something for nothing on the societal level. people shouldn't be upset. They are just paying back for what they voted or wanted since most people live beyond their means in credit societies. 

 

Edited by scorpioncapital
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There is a Canadian flip side to all this ..

If, within the next 5-10 years, you were planning to convert a portion of a RRSP into a RRIF; you are probably going to see a 'guaranteed' interest rate of at least 2-3x what you are seeing today. Terrible thing, to pass on such an opportunity 😁

 

SD 

Edited by SharperDingaan
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  • 1 month later...

Looking for advice on locking in a 30 year fixed at 4.1% or taking a risk on a 10/1 ARM 30 year at 3.3% and hoping I can refinance for under 4% before the 10 year is up. Do I take the sure thing in the 30 year fixed? Anyone have insight on how these rates pan out once inflation comes back down and we possibly end up in a true recession? I have never been the type to take the ARM loans. 

 

thank you in advance! 

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Posted (edited)
13 hours ago, ddriscoll9 said:

Looking for advice on locking in a 30 year fixed at 4.1% or taking a risk on a 10/1 ARM 30 year at 3.3% and hoping I can refinance for under 4% before the 10 year is up. Do I take the sure thing in the 30 year fixed? Anyone have insight on how these rates pan out once inflation comes back down and we possibly end up in a true recession? I have never been the type to take the ARM loans. 

 

thank you in advance! 

 

30-year can also be refinanced. I'd recommend 

  • Protect yourself against the probability that interest rates could be lot higher when your 10/1 ARM resets the rate
  • Set yourself up to benefit from the probability that interest rates fall below 3.3% at some moment in the next 30 years. 

 

So, I'd recommend going with 30 year. 

Edited by LearningMachine
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Posted (edited)
13 hours ago, ddriscoll9 said:

Looking for advice on locking in a 30 year fixed at 4.1% or taking a risk on a 10/1 ARM 30 year at 3.3% and hoping I can refinance for under 4% before the 10 year is up. Do I take the sure thing in the 30 year fixed? Anyone have insight on how these rates pan out once inflation comes back down and we possibly end up in a true recession? I have never been the type to take the ARM loans. 

 

thank you in advance! 

A lot of people don't stay in a house forever. If there is a significant chance that you are going to sell your house in the next 10 years, I would recommend the 10 year ARM.

Edited by Spekulatius
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Posted (edited)
16 hours ago, ddriscoll9 said:

Looking for advice on locking in a 30 year fixed at 4.1% or taking a risk on a 10/1 ARM 30 year at 3.3% and hoping I can refinance for under 4% before the 10 year is up. Do I take the sure thing in the 30 year fixed? Anyone have insight on how these rates pan out once inflation comes back down and we possibly end up in a true recession? I have never been the type to take the ARM loans. 

 

thank you in advance! 

 

I would absolutely do the ARM in this instance. Let's say the loan is $500K. In the first 10 years of the fixed ARM period the 3.3% rate loan assuming no extra payments pays $147K of interest. A $500K fixed at 4.1% pays $185K. Over the 10 years one saves $38K of interest or 7.7% of the loan value due to the lower rate on the 10/1. Additionally, the payment is $226/month less, so one could also theoretically use that freed up capital to make investments or additional principal paydown. If I make an apples to apples comparison (same payment / month) and apply the payment savings to the principal then the ARM will save $43K of interest over the first 10 years (8.6% of the principal value). The 3.3% loan payment is $2,190 vs $2,416 for the 4.1%

 

The ARM will be better off in the first 10 years. Thereafter, it may not be, but they typically can go up by only 2% / year and have an absolute cap on how much they can go up (when i took out mine, it could only go up by 5% cumulatively). Typically under a worse case scenario your breakeven will be in year 12-13 (ie you will have paid more interest on the ARM if rates go up a a lot after year 10 and that breakeven point is  a couple years after the rates start to go up). 

 

The typical american homeowner doesn't stay in their home that long. Even if you think you might, I'd go with the certain savings of the ARM in this instance. 

 

plug in your max potential rate on year 10 principal w/ 20 year amortization and see if you could handle that. that's an important risk mitigant.

 

In our $500K example, let's say rate immediately jumps to 8% in year 10. The principal is now $352K / term 20y, rate 8%) your payment would jump from $2,190 to $2,946 and interest / month would go from $~900 to $2,300, so you'd be paying $1,400/month more in interest in year 11....but you saved $38-$43K in the first 10 years so you're still much better off for many more months, so that's 27 more months.

 

At the risk of being repetitive, it's important to note that one will bear the risk of adjustment on a 10/1 on a much lower principal balance. In this case $352K/$500K (70%). If you can't handle the prospect of a big hike in rate on 70% of the  mortgage 10+ years out, you may be stretching on house. 

 

So I think I can say with a high degree of certainty, even if you never have a chance to refi, the 10/1 will leave you better off in the first 147 months of the loan or 12.25 years (and if i were to see the fine print on your loan and ascertain that the adjustment could only increase by x% / year and is capped at y%) then I may even be able to extend that further. I think when faced with something that will absolutely make you better off for the next 12+ years, but may have some risk of hurting you thereafter, you go with that, rather than paying a large "insurance premium" for the stability of a fixed rate just to potentially save you money in year 13. 

 

Go 10/1 ARM

 

I will admit there's a beauty to knowing that your p&i can never go up and I went fixed when i had chance to refi (3.125% 10/1 jumbo--->2.875% 30 yr conforming), but the rational choice is ARM in most cases particularly with such a big gap b/w 10/1 and 30 yr fixed like you are talking. 

 

 

 

Edited by thepupil
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I've changed my mind on this over the years.  Looking back I've owned 4 homes that I've lived in (not counting 2nd homes).   My first house I lived in 6 years, 2nd house 8 years, 3rd house 4 years, current house 7 years so far, but I paid off the mortgage after 6 years.  In every case I went with 30yr fixed mortgages, but would have been better off with 10/1 ARM.

 

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Posted (edited)
1 hour ago, rkbabang said:

I've changed my mind on this over the years.  Looking back I've owned 4 homes that I've lived in (not counting 2nd homes).   My first house I lived in 6 years, 2nd house 8 years, 3rd house 4 years, current house 7 years so far, but I paid off the mortgage after 6 years.  In every case I went with 30yr fixed mortgages, but would have been better off with 10/1 ARM.

 

 

 

Buffett would have knowingly chosen to make the same decision to go with 30-year mortgage even if his plan was to sell in 5 years: 

  • On Feb 27, 2012, he said he would buy a couple hundred thousand single-family homes if he could and sell them 5-years later, and even then choose a 30-year mortgage.  I couldn't find the original video but here is an article cnbc made based on it: https://www.cnbc.com/id/46538421 .   
  • On March 6, 2017, he reiterated that a 30-year mortgage is “the best instrument in the world. ... Because if you’re wrong and rates go to 2 percent, which I don’t think they will, you pay it off. It’s a one-way renegotiation. It is an incredibly attractive instrument for the homeowner and you’ve got a one-way bet."  He shared how unfortunately Berkshire doesn't have this same opportunity to call back a 30-year bond on par, and how this gift is available only to individuals.  See https://www.cnbc.com/2017/03/06/heres-why-warren-buffett-thinks-you-should-buy-a-home.html .
Edited by LearningMachine
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2 hours ago, LearningMachine said:

 

 

Buffett would have knowingly chosen to make the same decision to go with 30-year mortgage even if his plan was to sell in 5 years: 

  • On Feb 27, 2012, he said he would buy a couple hundred thousand single-family homes if he could and sell them 5-years later, and even then choose a 30-year mortgage.  I couldn't find the original video but here is an article cnbc made based on it: https://www.cnbc.com/id/46538421 .   
  • On March 6, 2017, he reiterated that a 30-year mortgage is “the best instrument in the world. ... Because if you’re wrong and rates go to 2 percent, which I don’t think they will, you pay it off. It’s a one-way renegotiation. It is an incredibly attractive instrument for the homeowner and you’ve got a one-way bet."  He shared how unfortunately Berkshire doesn't have this same opportunity to call back a 30-year bond on par, and how this gift is available only to individuals.  See https://www.cnbc.com/2017/03/06/heres-why-warren-buffett-thinks-you-should-buy-a-home.html .

 

I think Buffett gives generally good advice. I also understand the appeal of negatively convex callable 30 year mortgages, but the math is the math is the math. Unless you are highly certain your hold period is 13+ years, the 30 year fixed (with this rate differential) is likely to cost money. it's pretty expensive insurance. if that security is more valuable than the $10's of thousands one will likely forfeit for choosing the fixed, than that's fine, but it's not necessarily "optimal"...also if your mtg is manageable relative ot income/resources the risk is much smaller than perceived. 

 

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Posted (edited)
3 hours ago, thepupil said:

 

I think Buffett gives generally good advice. I also understand the appeal of negatively convex callable 30 year mortgages, but the math is the math is the math. Unless you are highly certain your hold period is 13+ years, the 30 year fixed (with this rate differential) is likely to cost money. it's pretty expensive insurance. if that security is more valuable than the $10's of thousands one will likely forfeit for choosing the fixed, than that's fine, but it's not necessarily "optimal"...also if your mtg is manageable relative ot income/resources the risk is much smaller than perceived. 

 

 

 

The issue is not the math based on highest interest rate we can imagine when looking backwards at periods of low interest rates.  The issue is risk management when looking forward, where we can't predict at all what future interest rates will be at the 10 year mark.  I don't think you can say with certainty that mortgage rates will be 8% at the 10-year mark.

 

If for a small amount, you can buy 100% certainty of not having to pay through the nose in interest rates at 10 year mark and for the subsequent 20 years, while getting the opportunity to refinance if interest rates were to drop, I personally would buy the insurance of 30-year mortgage. 

 

All that said, if the real estate will not cashflow positively with a 30-year fixed with actual or imputed rent, property taxes, insurance and maintenance, I wouldn't buy the real estate for investment purposes. 

 

 

Edited by LearningMachine
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Posted (edited)

I used 8% because it’s 5% more than the ARM. Many ARM’s have built in caps both in terms of aggregate increase in rate (ie your max rate is 8%) and how much rate can go up in a quarter or year. These have value to the borrower and substantially de-risk the ARM. 

I don’t know the poster’s precise terms but would be surprised if it’s uncapped 

 

Edited by thepupil
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here from quicken (top mortgage provider) talking cap… I can also say my Wells Fargo jumbo was structured similarly.
 

this provide one with ability to model the maximum risk which should be manageable 

 

anyways think OP should have info to make decision.

 

Adjustable-Rate Mortgage Margin

 

Margin is a percentage point predetermined by your lender that remains the same throughout the life of the loan. It’s used to determine the interest rate for loans. Once the initial fixed-rate term ends on an adjustable-rate mortgage, the interest rate typically adjusts annually, and this new rate is determined by adding the index to the margin. 

 

Although this may cause the interest rate to increase, there are caps on how much it can increase.

 

Adjustable Interest Rate Caps

 

  • Initial cap: The maximum amount that the interest rate can adjust the first time it’s changed after the fixed period.
  • Periodic cap: This puts a limit on the interest rate increase from one adjustment period to the next. The initial cap and the periodic cap may be the same or different.
  • Lifetime cap or ceiling: This puts a limit on the interest rate increase or decrease over the life of the loan, and all adjustable-rate mortgages have a lifetime cap. Although these limits are put in place for rate increases, rates can decrease, too. However, since the margin stays the same throughout the life of the loan and is added to the index to get the interest rate, the rate will never fall below the margin.

 

Adjustable-Rate Mortgage Cap Structure

 

Cap structure is a numerical representation of each cap for the loan. This is presented in a series of three numbers that represent the three caps: initial cap, periodic cap and lifetime cap.

 

For example, a common rate cap is 2/1/5, which breaks down like this:

 

  • Initial cap: Your initial interest rate can only change by up to 2% the first time it adjusts.
  • Periodic cap: Each change after that is limited to 1% every 6 months.
  • Lifetime cap: Throughout the rest of the loan term, the most the interest rate can increase or decrease is 5% from the fixed rate. So, if your original rate was 3.5%, your interest rate can only go up to 8.5% during the life of your loan.
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Thank you for all the thoughts! @thepupilI love your logic and well thought out processes. The only additional information I left out was I have three young kids (5,5,1) which will be going to public schools in this town. The town has great school (in Mass) and I can say with a high degree of certainty, we will be in this house until the youngest is atleast graduated from the high school (16 years from now). This is the reason I am leaning towards the fixed rate, however, I do not disagree with your math one bit. 

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