The term interest rate sometimes refers to the price a borrower pays a lender for a loan. Unlike other prices, this price of credit is expressed as the ratio of the cost or fee for borrowing and the amount borrowed. This price is typically expressed as an annual percentage of the loan (even if the loan is for less than one year). Today, financial economists often refer to the yield to maturity on a bond as the interest rate. In this article, the term interest rate will mean yield to maturity.
Supply and Demand
Interest rates form the clearing level between the supply and demand of credit. As the forces of supply and demand change, so do interest rates to bring the credit markets back to equilibrium. First we will consider the factors that affect long-term interest rate cycles on both the demand and supply sides.
For the demand side, the driving factors stem from the risks involved in owning the asset. As perceptions of these risks change, so does the valuation of the asset itself. For a debt holder, the first major risk is a lack of savings to fund repayment of principal when the time to maturity arrives. For high-grade bonds, such as the U.S. government debt we consider here, the repayment risk is a minuscule one and generally not considered in valuations. For a Treasury bond holder, the major risk to the investment is the erosion of value of the coupon payments and the principal through price increases. The economic term for price increases is inflation, while price decreases are referred to as deflation. Since the coupon and principal stay fixed for fixed rate bonds, increasing prices of goods and services in the economy essentially lower the value of future cash flows (consider the value of $100 today versus its value 50 years ago). If inflation is high, bond holders will demand higher interest rates to compensate for the possible loss of value. If deflation takes hold, the value of the future cash flows actually increases, making the Treasury instrument more valuable. For the buyer of a fixed rate instrument, the current coupon payment is a small percentage of the total value of the bond—most of the risk in the bond is from the risk of erosion of value of the future cash flows. Therefore, it is the expectation of future inflation that is most relevant as a factor, rather than the current rate. Essentially, inflation expectations are a driver of the demand for debt.
What drives inflation expectations? There are a number of factors for an investor to consider when assessing the inflation risk in a government bond. The economic cycle is intimately linked to investor perceptions of inflation. The dynamic between the economic cycle and inflation expectations is complex and can be affected in numerous ways. The simple story goes like this: As economic growth heats up, firms increase production to meet increasing demand. As production increases, the utilization of existing capacity increases, leading to demands for wage increases as labor becomes scarce. Wage increases induce price increases of goods, which in turn lead to further wage increases, causing a chain reaction. Due to this chain reaction, consumers and workers expect prices to rise in the future, which increases expectations of inflation in the future.
An important component in the link between economic growth and inflation is the increase in the utilization of capacity as the economy grows, leading to increasing wages and prices. Declining economic growth, except in cases of stagflation, can lead to decreasing prices and wages. Such a dynamic is known as deflation and generally is seen in prolonged slumps, such as the Great Depression in the United States or in Japan since the 1990s.
Another component of economic growth, government spending, can also cause increasing inflation expectations. The government sector has received more attention recently as government expenditures rose in response to increasing demands for social welfare programs and for government intervention in economic downturns. The first group of spending increases comprises structural government spending mostly unrelated to the state of the economy; the second group of increases is cyclical, rising and falling due to the economy. Excessive government spending can overheat the economy just as excess production from firms can, and it can have other effects on the private sector. As government spending rises, the increasing amount of debt the government needs to take on also crowds out private sector debt, leading to interest rate increases.
The long-term demand for borrowing by various economic entities can be aggregated and generalized as the leverage cycle. The term leverage refers to the amount of debt versus assets of either an individual or the economy as an aggregate. The leverage cycle has a strong effect on long-term interest rate cycles, but it is not as simple as increased borrowing leading to higher rates. Generally such processes are discontinuous; increasing amounts of leverage in an economy do not necessarily lead to steady increases in interest rates as a steady line.
The financial regulatory framework of an economy and the structure of its banking system also have an effect on the level of funds available for borrowing. Regulations that prevent inflow or outflow of capital can have a significant impact on domestic interest rates. If foreign inflows are prevented from entering the country, interest rates will tend to be higher than with an open economy; the reverse occurs if capital is held captive domestically.
The combination of economic data and related actions by the Fed creates cycles of interest rate movements that can last anywhere from a few months to a few years. The Fed directly controls the overnight rate in the United States, but its influence goes far beyond the short rate. This is because the short end of the yield curve is not independent of longer maturities. Short-term rates set the financing rates for longer-term assets; for example, the short-term rate set by the Fed is close to the financing repo rate for Treasuries. This way, expectations of forward Fed activity lead to expectations of forward financing rates and thus affect longer-term Treasury yields.
Why does the Fed not just raise or lower the target rate all at once instead of in steps? One reason is that monetary policy tends to act in lags, and large one-time increases may have unpredictable effects on economic growth or inflation expectations in the future. Another reason is to avoid excessive volatility in markets as very large, sudden rate increases or decreases may create significant uncertainty regarding the direction of Fed policy. In general, Fed policy occupies one of three regimes:
- Tightening, which refers to raising the target rate
- On hold, which refers to no change in the target rate
- Easing, which refers to lowering the target rate
The Fed acts as an external agency that attempts to reduce volatility of economic cycles by changing interest rates and conducting open market operations. These open market operations are meant to keep the short-term interest rates near the target and involve buying and selling Treasuries in the open market.
Economic data is crucial for any financial market to follow, but for a macroeconomic-driven space like rates, it is a significant day-to-day driver. The details of each piece of economic data are key to deducing broader trends in the economy. To understand these underlying trends, adjustments for unrelated or confounding effects such as seasonality, weather, calculation changes, or temporary government policy need to be accounted for. Evaluating economic data means looking at Gross Domestic Production (GDP), employment data, manufacturing data, and more.
Interest Rate Risk
Any security—such as a bond, loan, or any other contract with fixed cash flows over a certain period of time—is exposed to interest rate risk. Interest rate risk stems from fixed cash flows being received or paid, and therefore changes in the broader market interest rates can make these fixed cash flows seem more or less attractive. As this attractiveness changes, so does the price of the security. For example, if a trader buys a bond paying a fixed 5% interest payment and, immediately following this purchase, prevailing interest rates for similar instruments in the market rise to 8%, the 5% bond suddenly looks like a poor investment. If the trader tried to resell the 5% bond, other traders would demand a discount to accept a 5% rate when they can buy similar instruments paying 8%. This reasoning can explain why the 5% bond would gain in value if interest rates on similar instruments fell to 3%.
This example demonstrates why a fixed rate bond, or any other fixed rate instrument, is sensitive to interest rates. Notice the disclaimer about "similar instruments" in the last example. The interest rate that the fixed rate bond is sensitive to is always the rate being offered in the market on similar instruments. For example, a 10-year U.S. corporate bond will not be sensitive to changes in rates offered by 5-year Korean government bonds unless such changes affect rates of other 10-year U.S. corporate bonds. In the financial world, though, interest rates are highly correlated, making it crucial to track global flows and developments to effectively manage the interest rate risk. The degree to which a bond is sensitive to interest rate risk is known as duration, which is discussed later.
Numerous factors can affect rates. These factors are constantly in a state of flux with different factors increasing or receding in importance as the economic winds shift. Beyond the factors mentioned in this chapter, new factors are sure to emerge over time to affect interest rates. To deal with the dynamic nature of interest rate markets, it is important to approach them logically, taking into account drivers whose horizons range from decades to days. With rate markets, it is important to know the major drivers on long and short time scales; it is just as important to be on the lookout for new factors that may arise from time to time.
In general, the bond market is volatile, and fixed income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities). Fixed income securities also carry inflation risk, liquidity risk, call risk and credit and default risks for both issuers and counterparties. Lower-quality fixed income securities involve greater risk of default or price changes due to potential changes in the credit quality of the issuer. Foreign investments involve greater risks than U.S. investments, and can decline significantly in response to adverse issuer, political, regulatory, market, and economic risks. Any fixed-income security sold or redeemed prior to maturity may be subject to loss.
Any fixed income security sold or redeemed prior to maturity may be subject to loss.