Interest Rates 101 - Series 3

May 22, 2014 9:03AM CDT

If you missed Interest Rates 101 Series 1 and 2, you can find them here and here.

Most investors and traders care about future interest rates, but none more than future traders of stock index futures, interest rate futures, and currency futures. If you are considering a trade in any of these markets, you must ask yourself, “Do I think interest rates will rise in the future?” If the answer is “yes” then you probably want to avoid being long interest rate futures, or have some information between prevailing interest rates and yield duration (maturity) from short-term to long-term maturity rates.

Supply-Demand Phenomenon

So what moves the yield curve up or down? Well, let's admit we can't do justice to the complex dynamics of capital flows that interact to produce market interest rates. But we can keep in mind that the Treasury yield curve reflects the cost of U.S. government debt and is therefore ultimately a supply-demand phenomenon.

Supply-Related Factors

If the Fed wants to increase the federal funds rate, it supplies more short-term securities in open market operations. The increase in the supply of short-term securities restricts the money in circulation since borrowers give money to the Fed. In turn, this decrease in the money supply increases the short-term interest rate because there is less money in circulation (credit) available for borrowers. By increasing the supply of short-term securities, the Fed is “yanking up” the very left end of the curve, and the nearby short-term yields will snap quickly in lockstep.

Interest rates often remain flat during a normal (upward sloping) yield curve. Probably the best explanation for this is that, because a longer bond requires you to endure greater interest rate uncertainty, there is extra yield contained in the ten-year bond. If we look at the yield curve from this point of view, the ten-year yield contains two elements: a prediction of the future short-term rate plus extra yield (i.e., a risk premium) for the uncertainty. So we could say that, while a steeply sloping yield curve portends an increase in the short-term rate, a gently upward sloping curve, on the other hand, portends no change in the short-term rate—the upward slope is due only to the extra yield awarded for the uncertainty associated with longer-term bonds.

As Fed watching is a professional sport, it is not enough to wait for an actual change in the Fed Funds rate, as only surprises count. It is important for you, as a bond trader, to try to stay one step ahead of the rate, anticipating rather than observing its changes. Market participants around the globe carefully scrutinize the wording of each Fed announcement and the Fed Governors' speeches in a vigorous attempt to discern future intentions. The Fed increasingly tips its hand in advance.

When the U.S. government runs a deficit, it borrows money by issuing longer-term Treasury bonds to institutional lenders. The more the government borrows, the more supply of debt it issues. At some point, as the borrowing increases, the U.S. government must increase the interest rate to induce further lending.

In the upcoming series, I will be looking at demand-related factors. In the last of these series, I will be looking at inflation and fundamental economics

There have been entire volumes of textbooks written on interest rates, this report just scratches the surface.

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