In Part 1 and Part 2 of this series, we explored some of the basic building blocks related to interest rates. In this final part of the series, let’s consider what actually causes rates to go up and down. There is no easy answer to this question: interest rates are determined by a complex variety of market forces. But we can deconstruct the question into specific forces that generally have an impact on the direction of rates.
We start with the monetary policy activity of central banks like the U.S. Federal Reserve, the European Central Bank or the Bank of Japan. A central bank conducts monetary policy operations in accordance with its specific operational mandate – e.g. maintain a stable price environment, provide a financial platform for economic growth etc. In general, though, central banks have a variety of tools through which to influence interest rates. The U.S. Fed, for example, applies a tool called open market operations to influence the intraday rate at which banks lend to each other (the Federal funds rate). When you hear on the news that “the Fed lowered interest rates today” what they mean is that through its open market operations the Fed injected liquidity into the market that had the effect of making money more plentiful and thus its price (the rate banks charge each other for money) less.
In normal cycles the Fed will target lower interest rates if it wants to stimulate lending to encourage economic growth, and higher interest rates if it fears the economy is overheating and higher inflation is a risk. In response to the market crash and economic recession in 2008 the Fed brought its target rate effectively down to zero, where it remains today.
The Fed does not have direct control over longer-term interest rates; however monetary policy is powerfully felt throughout the credit markets. Interest rates are referential; that is to say, they refer to some other market benchmark and those reference points tend to lead back to central bank policy. Consider the U.S. Treasury market. Treasuries are issued in maturities from 30 days to 30 years. In the short end of the market rates will be very closely related to the Fed funds rate, which of course is also a highly liquid short-term rate. As Treasuries go “out the curve” towards longer maturities their interest rates reflect other variables on top of the present level of short-term rates. Most of the time, these other variables have the effect of making longer-term rates higher than shorter term rates (known as a normal or positive yield curve). Reasons for higher rates at the long end of the curve can include inflationary expectations, anticipating future central bank rate increases, and a risk premium for holding longer-term instruments (recall the risk relationship between time, prices and interest rates).
Perceptions of credit quality also influence the movement of rates. Going back to our earlier discussion about the anatomy of interest rates, investors demand a risk premium on securities that have higher risks than others. Again this a referential exercise – we consider rates for similar maturities of risk-free securities like U.S. Treasuries, and then figure out how much more compensation we require for investing in cash flows where we are less certain of the timing and magnitude of promised cash flows. These perceptions are always changing. If the economy is generally strong and businesses are healthy we expect fewer defaults (i.e. a higher probability that we will get all our promised cash flows on time) – and so our “risk spread to Treasury” will tend to be lower. If investors collectively see bad times ahead and are nervous about the health of borrowers then we should see spreads start to rise.
This is really only the tip of the iceberg of a very deep and complex topic. Our goal here is to equip you with some of the basic tools to understand credit markets. Understanding leads to prudent investment decisions, and it also makes the process of investing a lot more fun.
