Chapter 12
Interest Rates and Falsehoods

Interest rates, like London fog in a Victorian era movie, are ubiquitous and seep into almost every aspect of people’s economic life while still maintaining a certain air of mystery. To carry on the simile, even when the characters in the movie are all sitting inside by the fire, interest rates are out there impacting inflation, currency rates, car and home sales, and the decisions by companies to invest in new projects or not. Rates impact stock valuations as fixed income assets become relatively more or less attractive versus equities and funding costs for trading desks, hedge funds, and other margin loans move. Interest rates creep into every aspect of the economic and investment decision process.

Keep in mind that interest is the price of money. Specifically, it is the price to lend and borrow money. Your bank deposit on which you are paid interest is effectively a short-term loan to a bank. Most loans however have an interest rate and a payback date. The longer the date of payback, theoretically, the higher the interest rate. The reason for this is that money in your hands a month from now is more valuable than money in your hands ten years from now. If you are lending somebody money for ten years you are going to want to be paid more than if you lend it to them for a month. This is the main reason why there is a yield curve, in which, for example, a two-year bond typically pays lower rates than a ten-year bond. The interest someone is paid when they loan money along with any anticipated changes in the principle of the loan is the yield on the investment.

There are probably as many theories and ideas on why interest rates move as there are traders and economists. There is a theory that interest represents the time preference for money, where a person prefers cash now than later. There is a theory that interest rate levels are based on a liquidity preference instead of a time preference. There are also theories tied into inflation such as interest rates are compensation for inflation expectations. All these theories seem to be right some of the time, which means they are also wrong some of the time, because at different times rates move based on different reasons and combinations of reasons. Focusing on just one structural theory is bound to make you miss some of the changes that can help your investing.

However, interest rates are never left to their own devices. Central banks and fiscal policies are constantly influencing how interest rates move. Most central banks have price stability as their core mandate and their major tool to control inflation is interest rates. However, even if a central bank could use interest rates perfectly to control prices, there is no assurance that it would pick the right level of inflation to target. In the United States the central bank has a dual mandate that also includes employment. Having the dual mandate is more honest politically as no central bank can just focus on price stability without an eye on growth, employment, and other critical economic factors. But the major tool they must do all this with is various adjustments that focus on impacting interest rates. Specifically, central banks influence rates through regulatory control over the traditional banking system and certain short-term borrowing rates for banks as well as purchases of securities in the open market. Often when central banks assert themselves to try to change interest rates the yield curve gets distorted. This can be seen in Figure 12.1, which shows the United States yield curve often flattening during periods when the Federal Reserve was raising their key lending rate. However, it is unusual for central banks to raise rates if the economy is not doing well and there is always the fear that they will go too far and crush the economy by making the cost of capital too high.

With increased global capital flows, rapidly available digital data on global government bond rates and more financial innovation, interest rates appear to be more influenced by investors and speculators than at any time in the past. One sign of this is that the trading volume in United States Treasury futures has surpassed the volume in actual Treasury bonds, implying more speculative trading.44 This weakens central banks’ control and can change the patterns of interest rate movements. It appears that with more capital sources and information available rapidly on borrowing sources, the economic system can add leverage quicker than in the past and rate moves can impact more aspects of the economy.

Since the financial crisis, central banks have used more tools to influence the markets and theoretically add more stability. One of these techniques has been called quantitative easing (QE), which involves using the central bank’s balance sheet to buy a large amount of fixed income securities, such as mortgages, corporate bonds, etc. This takes bonds out of circulation and puts more cash into the economy, hopefully encouraging more lending. They have also influenced banks activities with regulatory and reserve requirements. The central banks need to be careful about political and legal backlash. They may overstep their mandate by pursuing some of the regulatory efforts, especially if they look beyond the traditional banking system to impose a regulatory agenda.

Some key points about central banks include: (a) their action generally only influence short-term rates and they assume the markets will transmit this to longer term rates; (b) their primary mechanism to exert pressure on rates is through the banking system, if banking becomes less central to the monetary system they might have less control; and (c) they have little control over fiscal policy and debt issuance by the government, theoretically the two can work at cross-purposes. When investing you want to watch what the central bank is doing, but do not kid yourself and think that they are completely controlling the rates or that their economic predictions are an indicator of where financial conditions truly are.

People watch central banks, perhaps too carefully, to try to figure out their future actions on interest rates. People analyze everything they do, looking for some signaling to see what direction they may go. The central banks keep a significant amount of controls around information. In the United States the central bankers have set cycles of press releases and their speeches are generally announced ahead of time and prereleased. The media and analysts use algorithms to do word searches on these speeches and press releases so they can rapidly “interpret” each announcement. Sometimes the markets will convince themselves that the change of one word in a meeting is a major interest rate signal and this will trigger a market reaction. On May 9, 2013, Chairman of the Federal Reserve Ben Bernanke utilized the word “taper” about the U.S. Federal Reserve’s bond buying program and triggered a “Taper Tantrum” causing the yield on the United States 10-year Treasury bond to go up by 65% over the next five months without any significant actions being undertaken by the Fed during that time, and well before there was any tapering.

Central banks do not always act the same, they may have certain rules and regularities around how they act, but stylistically the central banks can change. Central banks are made up of people and their personalities can influence the bank’s actions. The head of the bank usually defines the personality of the it and their terms are usually long. The banks are supposed to be politically independent, but virtually nothing in the world of human interaction is completely free of politics, especially if it is based in places like Washington, D.C. The change in the U.S. Federal Reserve leadership that occurred in 2018 may prove to be an interesting personality study. Both Ben Bernanke and Janet Yellen headed the Fed for about 12 years combined. Both were academically trained economists and had spent their entire careers in academics or the public sector. Their replacement was Jerome Powell. He was trained as a lawyer and spent many years in the private sector. It will be interesting to see what changes occur in how the bank acts and communicates with this new leadership. Economists from academia and the public sector are often very wed to their models. While they are aware that these are just models, they may be less likely to change policy if it does not fit this construct and they can sit patiently and wait for reality to conform to the model over time; this may make them less reactive to signals from the market. Lawyers tend to be advocates and very pragmatic and willing to change more quickly. This leadership transition may lead to differences in how quickly the Fed responds to moves in the markets and investors may take time to realize that there may be new developments in the central bank paradigm with a new person in charge. It is not the central bank but usually a treasury department that issues government bonds. In the countries of the highest credit quality the interest rate on government debt is often referred to as the “risk-free rate.” This is the case for countries like Germany, Switzerland, Japan, the United States, and a hand full of others. This does not mean that these notes do not bear risk from changes in interest rates; it means they do not have a risk of defaulting on their obligations. The difference between the government “risk-free” interest rate and the yield, or interest rate required on other types of loans of the same maturity is called the spread. This spread can be looked at as a measure of risk that a lender is requiring to get paid. If the five-year government bond is offered for sale at 2% and an investor is lending money to a company by buying its bond that matures in five years at 5%; the spread is 3. Usually, this spread is quoted in basis points45 (bp) so it would be +300bp. If that spread (i.e., credit spread) moves out to +375bp it implies that the perceived risk of that bond failing to pay back its obligations has increased. Obviously, many other things can influence that spread, such as supply and demand of bonds and the relative attractiveness of other investments as well as general economic and market volatility. However, spread is often viewed a measure of credit risk. These same factors are true with mortgage loans and other types of fixed income instruments. Examining the direction of the spread of different groups of bonds can give a good picture of how markets are perceiving risks in the economy or select parts of the economy.

Historically credit spreads on the debt issued by banks has been an interesting measure of perceived financial conditions. As financial markets evolve, banks are still an important part of the financial system, even though alternative financial entities are increasingly important. Bank credit spreads can be a valuable tool when comparing financial risks of various countries. Bank credit spreads are helpful to watch, but the value of this measure may diminish over time as other financial institutions evolve.

With huge amounts of capital some investors borrow money and use leverage to buy stocks so do not think that interest rate movements are a phenomenon impacting fixed income investments only. A small rise in rates impacts the return on leveraged stock holdings. The same goes for business investments. A project that can be funded with low interest rates may be less attractive if rates are higher. Having a view on the direction and level of volatility of rates is important and is part of the reason a company’s capital structure matters. A view on interest rates can cause shifts between where in the world of fixed income investments you might want to concentrate and whether you want to be in fixed income or equities.

Credit spreads can be a valuable tool for understanding the markets’ view on risk and a very good item to monitor. The increased access to capital from multiple sources other than banks and the increased trading volumes in government issued assets has changed the control that central banks have over interest rates. While it has not appeared in the economy recently, these dynamic non-bank flows of capital could lead to more volatility in interest rates over time. While many interest rate watchers focus on central banks, it is equally more important to be watching how long-term interest rates and credit spreads are acting in the markets as well as to monitor how much and what type of borrowing at the government, corporate, and household level is occurring.