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Interest Rates 101

Most people consider interest rates to be boring, but they are wrong! They tell you a great deal about the economy. Here are some “fast facts” about interest rates:

  1. Interest rates are a price – the price for money. Like all prices, it reflects supply and demand. If the demand for money increases, while supply remain constant, then the price or interest rate will rise. However, this is more true for longer-term rates than short-term rates, because the Fed keeps tight reins on short-term rates, while long-term rates are governed by the “market”.
  2. There are many types of interest rates, like the Fed Funds rate, which is directly controlled by the Fed. There are many others, such as the prime rate, mortgage rates, junk-bond rates, etc. They tend to move similarly but loosely.
  3. The “term structure of interest rates” explains that longer-term rates are higher than short-term rates, because more time means more opportunity for something to go wrong, like inflation.
  4. When short-term rates are higher than long-term rates, it is called “an inverted yield curve” and was considered predictive of a recession. However, with the Fed taking complete control of short-term rates since the Great Recession in 2008, it has raised those rates to fight inflation. The inverted yield curve is still mentioned but not relevant any longer. It is almost flat currently.
  5. Rising interest rates are a mixed blessing. It is good for savers but bad for borrowers, especially businesses. That’s one of the main reasons that stock market has been disappointing recently. Increased interest costs means less profit, which reduces the value of stocks.
  6. Large companies have greater access to the bond market than smaller companies. This makes it easier to borrow money for large companies. Many large companies were smart enough to lock-in low interest rates on their bonds, giving them an advantage over smaller companies, whose interest expenses have risen significantly.
  7. Interest rates also affect currency rates. International capital flows to where it is treated best. With interest rates higher in the U.S., foreign investors must buy dollars to invest in the U.S. stock market. An increased demand for dollars makes the dollar stronger, which it is currently.
  8. If the Fed raises interest rates this week, it will be minor disappointment to the stock market, which expects the Fed to “pause” or keep rates unchanged. If they cut interest rates, however, the market would be pleasantly shocked, rising substantially and quickly.