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2017 adding a new dairy variable: Rising interest rates

Progressive Dairyman Editor Dave Natzke Published on 06 January 2017

Along with the hope milk prices and income margins will increase in 2017, dairy farmers will likely encounter something else they haven’t seen in a while – rising interest rates.

After raising the benchmark interest rate just once in the last seven years (0.25 percent in December 2015), the Federal Reserve added another 0.25 percent in December 2016, and hinted three more increases may be coming in 2017.

Why the increases? In short, the U.S. economy is improving.

“The Federal Reserve has a dual mandate: Control inflation and keep employment in line,” said Sam Miller, managing director and head of agricultural banking with BMO Harris Bank. “The lengthy period of low interest rates in the U.S. has been because there has been limited inflation and the unemployment level had been high.”

With an improving economy, unemployment has been declining. Workers and wages are a major factor driving inflation, and indexes measured by Federal Reserve banks show monthly inflation rates averaged about 1.7 percent through 2016, moving closer to the Fed’s cap target of about 2 percent.

The relatively small interest rate increases reflect the fact the overall inflation “marketbasket” is still fairly stable. Besides wages, other factors driving inflation have been mixed. Petroleum prices, although still low, are higher than a year ago. Health care and housing costs have also been rising.

At the same time, prices for electronics and other consumer items have been declining. In the agricultural sector, food prices are significantly lower than they were a couple of years ago.

“If the Fed is saying they’re going to raise rates three times in 2017, they’re expecting inflation to increase a like amount,” Miller said. “They raise the rate so that the economy doesn’t overheat.”

Basis points and interest rates

The Fed changes interest rates in increments of “basis points,” with 100 basis points equal to a 1 percent change in the interest rate. So, the most recent increases of 25 basis points is equal to a 0.25 percent boost in the interest rate.

How does that translate to what interest rate a dairy farmer pays?

“For variable rate loans, for the most part it will be a 1-to-1 correlation,” Miller said. “Each 25 basis point increase announced by the Fed will boost interest rates on variable rate loans by about 0.25 percent.”

The basis point/fixed rate loan correlation is less directly aligned, Miller said. For fixed-rate loans, interest rates are also impacted by longer-term expectations for economic growth, employment rates and inflation. At the local level, lenders set rates for individual customers as a hedge against their own costs, including how much interest they pay to depositors.

While variable- and fixed-rate interest rates typically move in the same direction, fixed rates are typically higher than variable rates.

“Long-term rates have moved higher since the November elections,” said Chris Laughton, director of Knowledge Exchange with Farm Credit East.

On-farm factors

While the general U.S. population has seen little overall inflation, the impact on the farm has been more of a roller coaster.

“When grain and milk prices were rising, that was very inflationary,” Miller said. “Farmers expanded significantly. Another inflationary pressure, land values, went up. At the same time, the increase on the expense side was masked by increasing crop and milk prices.”

In the past couple of years, however, that’s changed. Prices received for commodities have come down, and while prices paid for many inputs – crop inputs and feed expenses – have also come down, they haven’t declined at the same rate as income.

Looking into 2017, Miller said discussions with clients indicate inflationary pressures on farmers shouldn’t change drastically. Fertilizer prices will be lower, while fuel prices will be higher than last year. Seed and chemical prices are expected to remain stable, while feed prices for livestock producers, particularly dairy, are expected to be lower than a year ago.

With a landscape of rising interest rates and stable on-farm inflationary pressures, how should dairy farmers manage finances in 2017? According to Miller, they’ve already been locking in rates.

“Keeping interest rates variable or fixed is not necessarily an easy decision to make, since interest rates on fixed-rate loans are typically 1.5 percent higher than variable-rate loans,” Miller said. “Even with anticipated increases in 2017, interest rates remain at historically low levels. If you fix a rate for five years, that means the variable rates have to move up pretty substantially for the bet to pay off.”

Amoritization – paying off debt on a fixed repayment schedule – also comes into play.

“If it’s a longer amortization, you’re paying more interest in the front years than you are in the later years,” Miller said. “Fixing that rate may make more sense, because you’ll have more time to get the benefit out of it.”

Risk management

Part of the objective is to take some of the risk of rising interest rates off the table.

“The longer-term fixed rates usually cost more, but it’s a hedge against variable rates moving up,” Miler said. “Like in anything, you typically don’t just make one bet. You don’t take the entire pile of debt and fix it for ‘X’ number of years. The best managers look at their interest costs as a basket, keeping rates affordable while providing some good interest rate risk management. Some of the shorter-term assets will be fixed for 1 to 3 years; some of the longer-term assets should be fixed from 3 to 5 years; and real estate will be fixed at 5-plus years.”

“Fixing the interest rate on a loan is essentially insurance against rising interest rates,” Laughton said. “With a variable rate, the borrower assumes the risk of rate increases, whereas with a fixed rate, the borrower has a measure of protection against that risk.”

“There is no rule or magic to timing a fixed-rate decision, nor is there a guarantee as to whether it will save or cost you money,” Laughton said. “If your business would face challenges in covering debt service with rates higher than current fixed rates, it may make sense to fix some or all of your loans in order to mitigate the risk of unexpected rate increases. For other businesses, it may make sense to stay with lower variable rates for now if your business can withstand the impact of rates rising faster than expected. It all depends on your business’s financial condition and your appetite for risk.”

For individual borrowers, BMO Harris Bank includes interest rates – along with income and expenses – in its “sensitivity analysis” when making lending decisions. The “shock test” forecasts expected impacts of lower income and higher expenses and interest rates on a farm’s cash flow and profitability.

For a “steady-state” operation, the analysis looks at changes of 5 percent on income and expenses and 2 percent on interest rates. For an expanding operation, those “shocks” increase to 10 percent on both income and expenses and 3 percent on interest rates.

Other impacts

Other than higher interest rates as a cost of doing business, rising rates have a two-fold impact on pushing farmland prices lower, according to Gary Schnitkey, ag economist at the University of Illinois.

First, higher interest rates increase the financing costs of land purchases, making it more expensive to debt finance farmland. Second, higher rates signal higher returns on alternative investments, thereby making alternative investments more attractive than farmland.

Optimism in 2017

Miller has an optimistic outlook for dairy in 2017.

“Working capital eroded significantly in 2015-2016,” he said. “The good news was that 2014 had been so strong, they had some reserves built up. Credit had been paid down, and cash was on the balance sheet.”

Even with lower milk prices in 2015-2016, some parts of the country faired better than others. In the Midwest, for example, feed piles entering 2017 are bigger and of higher quality.

Regardless of how much interest rates move, the “old standards” apply to dairy business management.

“Have the best cost controls that you can, manage your price risk, maintain your working capital position and have a strong equity position,” Miller said. “Now that we’ve seen some price improvement and expenses are marginally better, it’s time to rebuild reserves and work hard on getting the balance sheet in shape to handle the next period of adversity that is likely to happen. We have them every couple of years, and I wouldn’t expect that trend to change.”  end mark

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