One of the largest and most variable costs in grain production can be interest, especially if you have land debt. Interest rates have been in an overall downtrend for many years and lately have not been volatile. That could change. A major concept in good risk management is remembering that things never stay the same and can change when you least expect it.
What if interest rates increased four percentage points, which would still place them far below the highs of the early and mid-80s? It could impact your cost of production $5-20/acre for short- and intermediate-term interest costs. The increase in costs due to higher rates could be as much as $60/acre for long-term interest if your real estate debt approaches $1,500/acre. That can more than wipe out a $50/acre profit projection.
Short-term interest rates are controlled largely by the actions of the Federal Reserve. There are increasing concerns that the Federal Reserve could raise rates to slow growth and head off inflation, but we still cannot predict that action.
Long-term interest rates are determined differently. The market impacts long-term rates almost entirely. The market rate of long-term bonds is the basis for the rates charged by most long-term lenders. Interest rates follow an inverse relationship to bond prices. When bond prices reach their peak, interest rates reach a low point. (See the weekly bond price chart.)
In October '98, when bond prices were at a high point, we recommended to our clients that they go to their long-term lenders and lock in 15-year interest rates. When we made that recommendation, interest rates were at an all-time low and have increased since that time.
More importantly, note on the chart that in February of 1999 the price of bonds dropped below the previous reaction low that occurred in late July of 1998. A previous reaction low is the lowest point the market reached after making a new high (June 1998).
The last time bonds dropped below a previous reaction low was 18 years ago. No one knows what rates will do, but the market may be indicating that things are changing. From a risk management standpoint you may want to protect against rising rates.
What action should you take? We recommend locking in rates on long- and intermediate-term debt, if you haven't already. Short-term rates aren't as critical, but even those could be fixed for the remainder of the year 2000 just to protect yourself from a large market move. This would especially be prudent if your lender doesn't charge a prepayment penalty. If we're wrong, you can move down with the market and lock in even lower rates.
One final note. The interest rate upon which 30-year bond prices are determined was recently changed from 8% to 6%. Consequently, the bond price index changed from around 110 to 90, so as you watch these bond price trends, keep this in mind.