“Stocks were up today as the Fed left interest rates unchanged”.
“Rates on bonds at the long end of the curve rose on investor fears of higher inflation”.
Do you ever wonder what those market pundits are talking about? Interest rates are a bit like gravity: everyone knows they exist, fewer can actually explain how they work, and they are actually not too difficult to grasp once you understand a few basic rules and practices.
To begin, we need a foundational understanding of what interest rates actually are.
The anatomy of interest rates
Strip away the fancy financial-speak and here it is: interest rates represent the price of money. The market for money is similar to that for other commodities: some people have it and are willing to sell (supply side – lenders), others want it and are willing to pay (demand side – borrowers). The point where supply and demand meet is the rate a borrower will pay to a lender for credit. Consider a bond with a term of five years, a principal amount of $1,000 and a coupon rate of 5%. The borrower takes delivery of the $1,000 today with an obligation to pay that $1,000 back to the lender in five years. In the meantime, the borrower has the obligation to pay $50 in interest for each year that the bond is outstanding (usually in the form of annual or semiannual coupon payments), or $250 over the five year life of the bond.
All well and good, but how did the parties arrive at 5% for the interest rate? Consider the lender’s perspective. The lender has $1,000 and could theoretically do anything with it – buy a sofa or 100 CDs, for example, or put it into a savings account. So there is an opportunity cost to the lender if she is going to defer the use of that $1,000 for five years. This is the basis for what is known in finance as the time value of money, otherwise explained as “a dollar today is worth more than that same dollar in the future”.
How much more? Let’s first decompose the rate into a real and an inflationary component. Say the current rate of inflation is 2% and that is its outlook for the immediate future. At a minimum the lender has no intention to lose out to inflation: that 2% represents the rate’s inflationary component.
The remaining 3% thus represents the real rate, in turn comprised of a risk-free and a risk component. How do we figure this out? Remembering that the lender is foregoing money now for money in the future, this 3% represents the real (post-inflation) opportunity cost. Put another way, it is the lender’s assessment of a reasonable return for a project of commensurate time and risk. Let’s say that the current rate on a 5-year U.S. Treasury note (generally regarded as a risk-free investment) is 3.5%. That’s a 1.5% real rate on top of the 2% inflationary component. Now, our lender has done an assessment of the borrower’s financial condition and concluded that the borrower is a somewhat riskier bet than Uncle Sam. She concludes that investments with a similar risk profile are currently priced at spreads of about 150 basis points (1.5%) over the 5-year Treasury.
So in conclusion, our lender adds the inflationary component (2%) to the real risk-free rate (2%) and the risk premium (1%), and that’s the anatomy of the 5% rate.
Next in this series: Part II – Interest rates and time, and the relation of market rates to monetary policy.
