Comparing a Mahomes Injury to Rate Cuts

Noah, my grandson at Indiana University, is a sports betting whiz but knows nothing about the strategy of locking in interest rates early. So, when I tried to explain how the market sets forward rates and why those rates are unaffected by anticipated changes, he repeated it back to me using terms that he was familiar with. It made a great deal of sense, and I might start having him do the explanations to our clients.

“Let me help you out, Grandpa. Say that Patrick Mahomes gets injured in a game and the doctors say he will be out for two weeks. It so happens that the Chiefs are supposed to play the Jets in four weeks and, following the injury and prognosis, the bookmakers have installed the Chiefs as a 7-point favorite. Suppose that you really like the Jets and think getting seven points would be a great bet. The question is whether you should place your bet now and take the seven or wait until Mahomes is activated again figuring his return will increase the spread for the Chiefs and give you more points. Hey Grandpa, if you like the points now, take them. If everything goes as planned, the spread at gametime will still be seven points because the bookies are already figuring that Mahomes will be playing. If you don’t take the points now, it could go against you.”

Let’s repeat Noah’s scenario but substitute Mahomes with Jerome Powell and a rate cut in place of a return from injury. We end up at the same place. Through his remarks, Powell has indicated rate cuts over the next two years. Based on those expectations, the market has already priced forward starting rates and if the projections hold true, those rates will be the same when you go to set in two years as they would be if you set those rates today (to start in two years).

Now, assume you are building a project and wish to fix a rate for seven years at the end of construction in two years. You are also expecting short-term rates to drop during that period. If the Fed cuts as projected and its forecast is unchanged, those rates you could have fixed today will not fall because those cuts have already been factored in, just as Mahomes return from injury had been factored in. If you like the rate today, lock it in.

To Do Nothing is to Speculate

That may seem a bit counterintuitive but consider this; if you act now, you remove all the variables that could occur over the next two years. You are grabbing the proverbial bird in the hand. By waiting, you open yourself up to the unknowns. Maybe the Fed cuts in the two years will be steeper than projected and the 7-year rates will be less at that time. However, the Fed could also stop the cuts or even raise rates in that two years and the 7-year fixed rate would be much higher.

The bottom line is simply to understand that the forward rates have been established with expectations built in. Waiting may work for you or against you and the group really needs to ask itself if it can afford the downside. 

In our experience, a group of doctors building an office from which to practice are not speculators. They want to know what their rent will be and having to up it by $4 psf because a rate unexpectedly moved from what it was earlier is not a viable alternative. It is an outcome that can be avoided by “not speculating” and acting sooner rather than later.

All that said, I really don’t understand parlays and I am hoping Noah will be patient with me.