The Flinchum File

Thoughtful Economic Analysis and Existential Opinions
Subscribe to the Flinchum File
View Archives

Interest Rates 101

06/14/2017

A reader asked why Wall Street obsesses constantly about interest rates?  Whenever the Fed changes interest rates, they only do it by a quarter point, so what’s the big deal?

Simple question?  Yes.  Simple answer?  No!  Entire text books have been written on interest rates, but here are a few factoids.

Interest rates determine the amount of interest you pay on mortgages and other loans.  They also determine how much income you earn on bonds and savings.

Interest rates may be fixed or floating.  As the word implies, fixed rates are determined by a third party, usually the government, such as U.S. Savings Bonds, and those rates do not change until maturity.  Floating rates are determined by the supply and demand for those particular types of financial instruments, such as Treasury bonds.  Those rates fall when the demand for those bonds increases more than the supply of those bonds.  Remember, the value of bonds fall as interest rates rise, because the amount of interest paid remains constant, regardless of the value of the bonds.  (Dividing the constant payment by increasing bond value produces decreasing yield.)

Interest rates have many lengths or maturities.  Short-term rates are usually lower than long-term rates, because long-term lenders take more risk than short-term lenders, such as inflation.  The risk of inflation is greater over the long-term than the short-term.

Interest rates are economic indicators.  The relationship between short-term rates and long-term rates is one economic indicator.  An increasing difference means the marketplace thinks that either inflation is rising, which is bad, or economic activity is increasing, which is good.  A decreasing difference is often indicative of a pending recession.

Interest rates indicate the amount of fear in the market.  When the yield on Treasury bonds drops suddenly, it is because investors got scared of stocks, sold their stocks, and used the cash to buy bonds, which means the demand for bonds increased, which increases price, but which drives down the yield.

Interest rates are economic tools.  The Fed can control short-term rates easily, but not long-term rates.  If the economy is over-heating, the Fed raises interest rates to reduce corporate profits and growth.  If the economy is weak, the Fed does the opposite, as they did in the face of the recession in 2008/9.

Interest rates change currency values.  Suppose you are a German earning nothing on your cash-euros but you can earn 1% if your savings were in US dollars.  To take advantage of that increased earnings, you would have to sell your euros, which drives down the value of euros, and then you would have to buy dollars, which drives up the value of dollars.  So, increasing interest rates increases the value of the currency.

A mere discussion of interest rates can change the stock market.  If Fed Head Janet Yellen said that interest rates need to be “normalized” (read:  3%) quickly, the stock market will suddenly sink.  She doesn’t need to do anything except talk.

Libertarians believe democracy is never safe, when the Fed is meeting.

The Fed is meeting this week . . .

We are a fee-only advisor providing best interest fiduciary services to clients
in Chesapeake, Newport News, Norfolk, Suffolk, Virginia Beach, Williamsburg, and the surrounding areas of Hampton Roads.

CONTACT BAY CAPITAL ADVISORSWe Will Respond Promptly

Contact Us Bottom