FIN 335 Module 2 Interest Rates Assignment Example

Interest Rates and the Yield Curve, 2022-2026

[Student Name]

Southern New Hampshire University

FIN 335: Financial Markets

Module Two Assignment

[Instructor Name]

[Date]

The organization, setting and figures below are a composite written as a model document. No real employer, client, colleague or patient is described.

Interest Rates and the Yield Curve, 2022-2026

Introduction

Between March 2022 and July 2023, U.S. short-term interest rates rose faster than at any time since the early 1980s. Long-term rates rose too, but less, so for more than two years short-term rates exceeded long-term ones. For a composite community bank in Billings, Montana, that meant its funding costs rose faster than what it earned on loans and bonds. This paper explains why rates rose, why the yield curve inverted and how both changes reached the bank.

The Level of Rates

Consumer prices rose 9.1 percent in the twelve months to June 2022, the fastest increase in four decades. The Fisher effect holds that nominal rates move roughly with expected inflation, so that lenders are compensated for the loss of purchasing power. As inflation expectations rose, investors demanded higher yields on new bonds. The 10-year Treasury yield, about 1.5 percent at the end of 2021, approached 5 percent in October 2023 before settling in the low 4 percent range.

The loanable funds framework explains the rest of the rise. Large federal deficits increased the government's demand for borrowing, while the Federal Reserve, which had bought trillions of dollars of Treasury and mortgage bonds since 2020, began shrinking its holdings in June 2022. Less demand for bonds from the Fed and more supply from the Treasury both push bond prices down and yields up.

The Short End

Short-term rates are anchored by the federal funds target. The Fed raised its target range from 0 to 0.25 percent in March 2022 to 5.25 to 5.50 percent by July 2023, held it there for more than a year and began cutting in September 2024. Taylor (1993) proposed a simple rule: the policy rate should rise above its neutral level by more than any increase in inflation, plus a response to the output gap. With inflation running near 8 percent and unemployment low in 2022, the rule called for a funds rate far above the near-zero setting, which helps explain the speed of the tightening.

The Shape

The spread between the 10-year and 2-year Treasury yields turned negative in July 2022 and stayed negative until late summer 2024, the longest inversion on record.

Selected yields, end of period

The expectations theory explains the inversion. If investors expect short-term rates to fall, a long-term rate, which reflects the average of expected future short rates, will be below today's short rate. Markets believed the Fed would eventually cut as inflation fell. The liquidity premium theory adds that investors normally demand extra yield to hold long bonds, which usually makes the curve slope upward; for the curve to invert, expected cuts had to outweigh that premium. Estrella and Mishkin (1998) found that inverted curves have preceded most U.S. recessions, which is why the 2022 inversion drew so much attention, though a recession had not arrived by the time it ended.

Effects on the Bank

The Billings bank funds itself mostly with deposits, which can reprice quickly, and invests in loans and bonds, many at fixed rates. About half its loans are fixed for three to five years, and its $620 million bond portfolio was bought mainly in 2020 and 2021 at an average yield of 1.7 percent. As the Fed raised rates, money market funds began paying 5 percent, and depositors moved balances into them or demanded higher rates on certificates of deposit. The bank's cost of deposits rose from 0.15 percent in 2021 to 2.05 percent in 2024.

Its asset yields rose more slowly, as old loans matured and were replaced over several years. As a result, net interest margin, the difference between what the bank earns on assets and pays for funding as a share of assets, fell from 3.62 percent in 2022 to 3.05 percent in 2024.

Bank margin, 2021-2026

Deposits fund about 85 percent of the bank's earning assets, and the rest comes from equity and a small amount of borrowing, so the margin is not simply the asset yield minus the deposit rate. The direction is what matters: the bank's funding cost rose by almost two points while its asset yield rose by less than one. The inverted curve made matters worse, because the bank could not earn more by lending long than it paid to borrow short. Mishkin and Eakins (2018) describe this mismatch as the central interest rate risk of banking.

Risk Premiums

Rates on riskier borrowers moved somewhat differently from Treasuries. The spread between corporate bonds rated BBB and Treasuries widened briefly in 2022 and again during the bank failures of March 2023, then narrowed as fears of recession faded. For the bank's farm and small business borrowers, whose loans are priced at a margin over the prime rate or Treasury yields, the main change was in the base rate rather than the spread. A cattle operation that paid about 4 percent on an operating line in 2021 was paying close to 9 percent by late 2023.

Recovery

Since the Fed began cutting and the curve returned to an upward slope, the bank's margin has started to recover. Long rates did not fall with short ones; the 10-year yield actually rose in late 2024 as investors demanded a larger term premium for holding long bonds amid large federal borrowing, an example of the liquidity premium at work. Deposit costs have stopped rising, and maturing loans and bonds are being replaced at higher yields. The margin was 3.18 percent in the first half of 2026, still below its 2022 level.

Conclusion

Inflation pushed the level of rates up through the Fisher effect, policy drove the short end through the Fed's rapid tightening, and expectations of future cuts inverted the curve. For a bank funded short and invested long, the result was a squeeze on its margin that is only now easing. Later modules examine the Fed's actions in more detail and how the bank can manage this risk.

References

Estrella, A., & Mishkin, F. S. (1998). Predicting U.S. recessions: Financial variables as leading indicators. Review of Economics and Statistics, 80(1), 45-61. https://doi.org/10.1162/003465398557320

Mishkin, F. S., & Eakins, S. G. (2018). Financial markets and institutions (9th ed.). Pearson.

Taylor, J. B. (1993). Discretion versus policy rules in practice. Carnegie-Rochester Conference Series on Public Policy, 39, 195-214. https://doi.org/10.1016/0167-2231(93)90009-L