A sharp move higher in interest rates has received a lot of attention lately. In fact, I now believe the focus on interest rates will move to center stage in our Brave New World of the Uncle Sam Economy. Allow me to comment.
I spent my entire career on Wall Street within the bond market, so my professional life has been consumed by interest rates. I don’t know if that is necessarily a good thing, but that’s for another day.
What are interest rates?
Very simply, the interest rate – for whatever financial product – is the “price of money.”
What are the components of interest rates for respective financial products?
Interest rates are determined by three factors:
1. a general level of rates of return in the economy and market: this level is typically viewed by focusing on the shorter maturity U.S. government securities. Uncle Sam is viewed as the benchmark from which all other interest rates are compared. Uncle Sam’s own creditworthiness is coming into question, but that can be a topic for a separate post.
2. a risk component: this factor addresses the creditworthiness of the borrower (be it a global government, a corporation, a municipality, or an individual). Additionally, while most bonds focus on the risk component as being a function of creditworthiness, there are other risk factors as well, including prepayment risk for mortgages.
3. inflation/deflation: this factor addresses how fixed future returns on bonds are impacted by the general change of prices in the economy. The presence of inflation (a rising level of prices) erodes the value of fixed future returns. In a similar fashion, the presence of deflation (a declining level of prices) increases the value of fixed future returns.
Utilizing these three factors, one is prepared to more effectively understand the nature of interest rates, both from a static standpoint and in a dynamic environment.
Utilizing these components, how and why do interest rates change in a dynamic economy?
Let’s recall that the valuation of any financial product (a stock, bond, currency, commodity) is determined in a dynamic market setting by buyers and sellers assessing three variables:
1. fundamental analysis: from our trusty Investing primer (right sidebar), we see this variable defined as:
an investor can perform fundamental analysis on a bond’s value by looking at economic factors, such as interest rates and the overall state of the economy, and information about the bond issuer, such as potential changes in credit ratings.
2. technical analysis: again using our Investing primer:
A method of evaluating securities by analyzing statistics generated by market activity, such as past prices and volume. Technical analysts do not attempt to measure a security’s intrinsic value, but instead use charts and other tools to identify patterns that can suggest future activity.
3. market psychology: the Investing primer educates us on this variable as well:
The overall sentiment or feeling that the market is experiencing at any particular time. Greed, fear, expectations and circumstances are all factors that contribute to the group’s overall investing mentality or sentiment.
While conventional financial theory describes situations in which all the players in the market behave rationally, not accounting for the emotional aspect of the market can sometimes lead to unexpected outcomes that can’t be predicted by simply looking at the fundamentals.
Utilizing these tools, let’s review the prevailing level of interest rates in our economy from a chart provided on a daily basis at the WSJ Market Data page.
We can assess how all the short term interest rates have come down over the last three years in response to the recession. We are now faced, though, with a move higher in rates given the increased risks of inflation, along with massive demand by global governments, corporations, municipalities, and individuals for credit. That demand, like any demand, is driving the price of money (the interest rate) higher. Is this demand being generated by improvements in the economy, the need to refinance existing debt, or a combination of the two?
Welcome to the word of interest rate analysis for fixed income investments (bonds).