Practical Dad

PracticalDad Primer on Interest Rates

Congratulations, interest rates are now as low as they've been since when Ike was President as the interest rate yield on the 10 year Treasury note blipped below 2% on August 18, 2011.  2%.  2%.  2%.  The most appropriate response can be genteelly texted as WTF?  But to get a flavor of what that actually means, you have to have a sense of what interest rates used to look like before the Federal Reserve System began altering the rate's genetic code, such as just done by the scientist who gave an alligator snout to a chick in utero.

The interest rate was once the prime food source for those who were looking for a steady income stream, whether they were banks or the elderly who were no longer in the work force.  It's true nutrition lay in the meaty, rich segment known as the real return and that in turn was protected by relatively thick layers that fended off the rate's principal predators, risk and inflation.  Since the rate's capture and subsequent alteration, the banks have been forced to find other ways to boost their income stream while the elderly have sometimes had to rely on their alternate food source, cat food.

There are even different breeds of interest rates and how they respond to the twin predators, risk and inflation.  All of them are wary of inflation and the longer-term bonds are not only more nervous, but also typically have much larger inflation layers to protect the real rate.  The government bonds are less concerned about risk than their corporate brethren, which have significantly larger risk layers as a result.  All of the rate breeds get more nervous when the economy is uncertain but the short term government breed responds like a St Bernard while the 30 year corporate and junk breeds are chihuahuas on a meth bender.

Snark and foolishness aside, there are some things to understand when you hear about interest rates and yields.  Understand this:  while everyone hears about the stock market and equities, the reality is that they're a sideshow to the bond market's main stage, upon which rests the various national debts and the supporting currencies.  James Carville once remarked that when he died, he wanted to come back as the bond market.

James Carville was right.

What is an Interest Rate?

Interest rates are nothing more than the cost of borrowing money, much as you'd pay Days Inn for the cost of using their room for a night or Hertz for the cost of that rental car during vacation.  Borrow from me and it will cost you perhaps 3 or 4 or 17 cents for every dollar that you use.  It could be 3, 4 or 17 cents depending upon any of the components that typically comprise interest rates.

Interest Rate Components

Historically, interest rates are composed of three segments. 

  • The first is the real return and this is generally what the lender would like to see as a true return for lending the money to a borrower for using his money.  It is a function of the lender's preferences and also what other uses he might have for the money.  Hey, if I can't get at least 4% real return on my money, then what's the point of lending it?  I can use it for my own purposes. 
  • The second component is that which pays the lender for what she assesses as the risk of the return of the money and it's here that the ubiquitous credit scores come into play.  If you've been bankrupt like Trump or planning to spend the money on a risky private space exploration company and you're liable to find that the lenders are going to ask for a higher interest rate to compensate them and this will be tacked onto the real return that the lender wants.  Historically, interest rates are generally higher as you go further out since there's greater uncertainty as to what's going to happen and that's why the 48 month CD rate pays you a generous 1.0% versus the .3% on the 6 month CD. 
  • The third component is the segment that compensates the lender for what they anticipate the rate of inflation is going to be.  Bonds pay at a constant rate and that is consequently eroded over time by inflation, which eats away at the purchasing power of the currency.  If you know that you're going to be repaid $1000/month over the next ten years, then you certainly want to assure that there's some extra sweetener since $1000/month won't buy in ten years what it buys now.

So the interest rates that you knew in the past were comprised of each of the three elements together.  When rates spiked in the early 1980s, that was a function of the Federal Reserve driving rates up with a healthy inflation premium to combat the effects of inflation rippling through the country at that time.  If you miss a credit card payment and the rate is raised, that's a function of the bank's response to what they perceive as the increased risk that you'll default and walk away; the amount of the rate increase is certainly debatable but the rationale behind it isn't. 

Yield

When you hear about the yield on a particular type of bond, you're hearing about the interest rate of the actual return on what was paid for the bond when it was actually purchased on the market.

Bonds all have coupon rates stating that they'll pay $X per each month or year and the face value of the bond is the amount that will be paid off when the bond reaches maturity.  Consequently, a company issuing new debt might agree to pay $400/year for 15 years on a bond with a face value of $10000 so the stated rate of the bond is 4% annually ($400/10000).  But let's say that the bond buyers believe that in the next 15 years, inflation is going to run at a rate of 5%/year so there's actually a 1% loss of purchasing power to the holder of this 4% piece of dogfood.  The company needs the money and the sale goes through; where the adjustment occurs is in what folks are willing to pay for the loss of purchasing power and that's the bond's face value.  I'll lose 1% annually over 15  years?  Meh, I'll bid $8500 for it and if I can get the $10000 for $8500, then that's good enough for me.  The actual interest rate yield on the bond is consequently 4.7% ($400/8500).  The annual bond payments are still $400 but the bondholder paid less for the bond and that's the value on which the yield is calculated.

The takeaway from the bond market is this:  bond yields are inverse to bond prices and bond prices are a function of supply and demand.  Yields drop because prices paid for bonds rise and vice versa.  If the yield on a particular class of bonds drops, then that's because folks are willing to pay something extra for that bond. 

How Are Interest Rates Set?

That's a hard question because it's an interplay between the Federal Reserve and the generalized market.  Understand one thing, first.  There's constant, constant lending going on between banks and investment houses on any given day as these entities are all shifting liquidity back and forth to cover their needs and many of these are lending to one another on an extremely short term basis with what appears to be minisculely at low rates - until you understand that these rates are on amounts often in the millions and for that day alone.  But these have to be predicated upon some standard and for the United States, that standard is the Fed Funds rate, the base interest rate at which banks lend to one another or borrow from the Federal Reserve for their everyday needs.  Presently, the Fed Funds rate is a whopping .25%, which means that banks have an extraordinarily cheap source of funds and the idea is that as the Fed Funds rate is adjusted one direction or another by the Federal Reserve, this will provide some guidance on where rates are supposed to go in the rest of the credit markets.

Which is great unless you've got a credit card at 11%+  interest, but that's not the purview of government regulation, which would be wrong. 

The Island of Doctor Bernanke (and his sidekick, Igor Geithner)

What's written above is a short and simplistic view of how things are supposed to work.  Our situation however, is that there's so much debt overhanging everything that Dr. Bernanke - he's a Ph.D - has had to tinker with the interest rates in order to try to keep things afloat.  The hope now is that the easy money policy will somehow flush through the economy and create inflation so that the massive debts are covered by devalued dollars.  How has he done that?

  • First by removing the ability to assess risk.  When the financial sector understood that it wouldn't suffer from it's mistakes and also had access to historically cheap credit, there was no impetus to monitor their lending; this resulted in all manner of bad loans for which they accepted the fees but ultimately never the loss.  As low as mortgage rates were in the height of the housing bubble, you can argue that the lack of risk was passed along to the homebuyer with the compression of the risk segment of the interest rate.
  • Working with the Government, the inflation portion has been gamed with reporting of the CPI, particularly when decisions are based upon the core-CPI, which consists of apparently everything from xBoxes to sneakers - but not food and fuel.  When the Fed Funds rate is based upon inflationary expectations that are managed instead of actually reported, then those who depend upon interest for income suffers.  The elderly who live on their savings and Social Security will see their buying power eroded as the inflation segment of interest rates is eviscerated while inflation begins to rise for food and fuel, pretty much what they use instead of xBoxes and sneakers.

How badly has the interest rate system been screwed because of these factors?

The fact that yields on the 10 year government note pierced below 2% meant that buyers wanted the safety of government bonds in hard times and were willing to accept 2%;  the expectation is that we're looking at a significant recession with deflation facing us as in the Great Depression.  That same day however, the yield on the 5 year TIPS note - which is adjusted for inflation so that the holder gets payments that adjust upwards for inflation - actually went negative.  In other words, people were actually willing to pay so much for the inflation adjusted bond that they bid the price up to the point that the yield was less than 0%.  And that is something that is rarely ever seen.

Congratulations, Dr Bernanke.  Your experiments on the poor interest rate have effectively made the bond market totally schizophrenic.  Welcome to the 21st century, where gene-splicing meets economics.

 

 

 

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