Interest Rates

Interest Rates

Note

Data on this page was last updated on December 05, 2022

Let’s start by defining what I mean by interest rates. Interest rates are the rate that a borrower pays a lender for access to funds that will need to be paid back. In simple terms, it is the cost of money—many debt instruments in the financial markets ranging from overnight banking to high-yield corporate debt. When studying interest rates, start with government debt because other forms of debt typically follow government debt because of risk arbitrage. Regarding interest rates, arbitrage is a simple concept; when investors choose to invest at the same rate, they will pick the less risky option. In this case, the U.S. is known as the safest investment because it is backed by the full faith of the U.S. Government. Setting the floor for They are setting rates because one would have to assume the additional risk of purchasing a different type of debt and is expected to receive a high yield, known as a risk premium. The Federal Reserve is the primary force controlling this money supply and thus interest rates through arbitrage.

For this part of our analysis, we will be focusing on government debt and monetary tools used to control government debt. The credit cycle section will cover interest rates on mortgages and corporate bonds.

The Yield Curve

From an investment perspective, the yield curve is one of the most valuable tools for measuring the trust of monetary policy. The monetary policy cycle swings from being accommodative, stimulating the economy to being restrictive, slowing the economy. The yield curve will be steepest when the Federal Reserve is most accommodative. And when the yield curve is inverted or at its lowest point, the Federal Reserve is at the maximum restrictive point.

The yield curve represents the different interest rates offered to the private sector by their maturity, except the federal fund rate (FFR). The federal fund rate is when commercial banks borrow and lend their excess reserves to each other overnight. The FFR sets the pace for interest rates, controlling the far left of the yield curve. The Treasury yield curve can change in various ways: It can move up or down (a parallel shift), become flatter or steeper (a shift in slope), or become more or less humped in the middle (a change in curvature).

To your right is a graph of the current yield curve. Consider three elements of this curve. First, it shows nominal interest rates. Inflation will erode the value of future coupon dollars and principal repayments; the real interest rate is the return after deducting inflation. The curve, therefore, combines anticipated inflation and real rates. Second, the Federal Reserve directly manipulates only the short-term interest rate at the very start of the curve. Third, the rest of the curve is determined by supply and demand in an auction process.

In the long run, Treasury yields tend to move together. It depends on external forces that drive each part of the curve in the short run. The following chart compares the 10-year Treasury note yield (blue line) to the two-year Treasury note yield (orange line).