Terms

Yield

The interest rate is how much a person/entity pays to borrower money from a lender.

More About Interest Rate

  • Interest Rate = Price of Money
  • Interest rates measure:
    • the supply and demand for credit
    • time preferences
    • inflation expectations
    • confidence in the currency
    • expectations for other investors expectations (especially the FED's)

Why are Interest Rates Important?
  • They are the traffic signals of investment
  • They measure time preference
  • They calibrate risk
  • They set investment hurdle rates
  • They have a huge impact on:
    • banks
    • real estate market
    • auto industry
    • etc.
  • They can fuel or crate prices of other assets like stocks and real esate
    • Low rates tend to increase the price of other assess as they become cheaper to finance and reduce discount rates
    • High rates tend to decrease the price of other assets as they become expensive to finance and increase discount rates 
Interest Rate Forecasting
  • Forecasting interest rates is extremely difficult - there are countless factors
  • Some consider it to be impossible
  • Central banks often try to forecast interest rates, but are proven incorrect over time

What Determines the Interest Rates

  • Short and long term interest rates are driven by different forces
    • Long-term rates are usually higher than short-term rates (more uncertainty)
  • Rates can be driven by Central bank Actions
    • Short term rate adjustments
    • Quantitative Easing (asset purchases) to drive long-term rates
    • Forward Guidance (Telling the markets what it plans to do)
  • Interest rates tend to move in long-term cycles:
    • 1900 - 1920 rising interest rates & inflation
    • 1920 - 1946 falling rates 
    • 1946 - 1981 rising rates
    • 1982 - 2016???? (end dates still tbd) falling rates
    • Interest Rate Cycles are Natural:  People first consume more than they can produce (rates go up), then later they have to pay it off (rates go down)

What Drives Short-Term Interest Rates

  • The supply and demand for credit determines short term interest rates (liquidity effect)
  • Short term interest rates are driven by the Federal Funds rate
  • The further out the yield curve you go, the less influence the federal funds rate has


What Drives Long-Term Interest Rates

  • Long term interest rates are driven by the markets expectations for economic growth and inflation
  • Long-Term Treasury Bond Yield = Real Rate + Inflationary Expectations
  • See the Fisher Equation
  • Dr. Lacy Hunt Model:
    • Long-term interest rates are driven by the aggregate demand for money
    • Long-term interest rates are driven by the Monetary Base (MB) * the money multiplier (m) * the velocity of money (V)
      • The aggregate demand is the same thing as GDP (AD = GDP)
      • GDP = M2 * V
      • ==> AD = GDP = M2 * V
      • M2 = MB * m
      • ==> AD = MB * m * V


US Historical Interest Rate Levels (Short Term Fed Rate)

  • Rates generally rose in the 1960s and 1970s
  • Rates mostly above 2.5% from 1960s to 2010
  • Rates mostly above 5% in 1970s and 1980s
  • Rates jumped to 10% - 19%+ in late 1970s and early 1980s
  • Rates started to decline around 1980 into 2016 (end still TBD as of 2018)
  • Rates at historical lows from 2010 onwards (after great recession and FED QE Programs)


  • Historically 10 year yields  have traded inline with GDP growth (relationship stopped after 2008 crisis & QE Interventions)