Interest Rates and Marty McFly

Interest rates are not drawing the main headlines but they contribute to the current risk environment and like oil prices, could have us all ooing and ahhing in a flash. For one thing a rise in interest rates could quash an economic expansion by making loans for housing, durables, and equipment more expensive. Even more worrisome is that a significant rise in rates could also make government spending rise making it that much more difficult to solve our deficit and debt problems. So a big question is when rates will begin to rise and by how much.

To answer these questions requires either Marty McFly and his time machine (1985 movie Back to the Future) or a healthy jigger of JD. Since the former is remote and the latter is filled with its own risks, we are left with a sober reflection on the things that tend to produce interest changes. This requires that we talk supply and demand but before we get to all that excitement let’s make sure that we all are on page 1 – that is, what do we mean by the interest rate?

At this point the reader who would not enjoy a delightful but long-winded primer on interest rates might want to skip down to the place marked XXX. After the XXX is where things get really juicy.

The interest rate according to Wikipedia is “the rate at which interest is paid by a borrower for the use of money that they borrow from a lender. Are you asleep yet? What immediately comes to mind at this point is the swimsuit edition of Sports Illustrated. But never mind that – what is relevant is that you can imagine a lot of different items that might fit that description. For example you could borrow $50 today from Uncle Bob and only give him $45 back tomorrow. In that case the interest paid would be -$5 and you would have received a -10% (negative) interest rate. This is unusual and not in Uncle’s Bob’s favor as a lender and more than likely was the result of making the transaction when Uncle Bob was on his third martini. More likely you might borrow money from a bank (for a car or a house) and we would normally call that a car loan or a mortgage. In either case you would complete a 700 page loan  application form and sign in blood that you would not only pay back the principal but also something called interest. When I bought my VW Bug in 1966 I borrowed $1666 and promised to pay each month until I had paid about $1800 in full. The interest rate on that loan was about 3%.

Loans from Uncle Bob and loans from a bank are just the tip of the iceberg when we consider interest rates. A more common form of credit comes from what we call bonds. A bond is a security which is a contract between the borrower and the lender. Instead of a passbook you get a piece of paper or a contract. Most bonds have the interest rate printed on this contract – this is called the coupon rate. So let’s suppose you buy a bond issued by Groupon Company. That means you are lending money to this company. On the bond it might say $5, $100, 2022. That information means that each year you hold the bond security you will be lucky enough to receive $5. Since the principal value of the bond is $100, your coupon yield or rate is 5%. When the bond matures in 2022 – they will pay you the principal of $100.

The coupon yield is important but when experts talk about interest rates rising and falling, they are usually referring to yields or returns available in the bond market. These market rates can be quite different from what was printed on the bonds. The bond market is where we trade the bonds that were issued and are still outstanding. Let’s suppose you bought the above Groupon bond and have it sitting happily in your safe deposit box along with your family’s jewels. And then it occurs to you that Groupon is struggling to succeed and you decide that Groupon might not be around in 2022 – and maybe not even in 2012. You call Max your friendly bond dealer and ask her to sell your bond. But on the day she sells it, Groupon might be selling for only $50. If old Lar decides to buy that bond at $50 -- the bond that says $5, $100, 2022 – then old Lar is admittedly taking a little risk but he is getting a 10% market return. Why? Is it his good looks and charm? Is it his James Brown-like dancing ability? No – it is because a bond old Lar bought for $50 gives him $5 per year. That’s a 10% return.

Much of what we read about in the press with respect to interest rates focuses on bond prices and market returns. Anything which causes the market price of bonds to rise one day – leads to lower market returns (or we say lower interest rates)  – since buyers are paying more for a given coupon. On days when bond prices are falling, then purchasers are receiving a higher interest rate since they are getting higher rate of return for a given coupon.

One more bit of background. The credit market is huge and diversified. There are government bonds and private bonds. There are bonds that mature in 30 days while others mature in 30 years. There are many categories of bonds and then there are many kinds of bank loans. Yet with all this diversity we utter a strange euphemism in public places like – how’s your stupid kid and what’s going on with the interest rate today? 

We talk about THE interest rate as if it was one of your kids. Since it is true that rates on all of these kinds of credit instruments often move somewhat together, we simplify by talking about the interest rate. Of course we all know that this is just a summarization and if you are only interested in a 6 year car loan in Bloomington Indiana, then you better get beyond discussions of THE interest rate.

Okay I have written so much that I need a potty break so please give me a minute.

I feel much better now, thanks for asking.

This is the place marked XXX. Now the plot thickens.

All the above is necessary to support the idea that if you want to talk about interest rates, then you need to talk about supply and demand. Remember, supply and demand is the economist’s tool for understanding price changes. If the demand for tickets at the Indiana University-Purdue University basketball game increases, then we would expect a rise in the price of the tickets. Similarly if the demand for bonds is generally rising faster than the supply then that should lead to a rise in bond prices and THEREFORE a reduction in market interest rates.

A general summary of this point is as follows –

• ·         If bond demand is rising relative to bond supply then interest rates fall.
• ·         If bond demand is falling relative to bond supply, then interest rates will rise.
• ·         So all we need to do is focus on the demand and supply of bonds if we want to predict the future course of interest rates.

Who supplies bonds? That activity is done primarily by lenders and by speculators who see the present time as a good time to sell bonds (these speculators are predicting a future decline in interest rates). The lenders are mostly private companies who borrow to purchase equipment and structures or by governments that have budget deficits. As the US and world economy begins to recover and grow, private borrowing and therefore the supply of private bonds should increase. As the US and other governments encounter high and rising budget deficits, they will have to sell a large and rising about of bonds. Of course, anyone with an outstanding bond – whether you call them a speculator or not – with expectations that selling a bond in the future might be more difficult or less rewarding – may want to sell their bonds in today’s financial environment.

Who buys bonds? Bonds are purchased by savers – by people who see bonds as one way to invest their money. They have decided to not spend some portion of their income and if they demand bonds they have also decided not to use the filthy lucre for other saving options like saving accounts, equities, life insurance policies, gold, or Cuckoo Clocks. The economic instinct is to buy a bond today if the return looks good (bond prices are low) or if you think bond prices will rise in the future. Of course much depends on the risk they estimate for the bonds. If savers believe that bonds are now safer than they were a year ago, then they are more likely to be buying bonds today. But much also depends on the riskiness or confidence these savers have for stocks and other investments. If during the financial crisis people put their money into commodities and very short-term safe bonds, then today a more optimistic public might be ready to move out of bonds and move their money into higher yielding equities. This would diminish the demand for bonds.

As things stand right now a simple look at the bond market could envision a very strong increase in the supply of bonds (shift the supply curve to the right) and a less marked but measurable decrease in the demand for bonds ( a shift leftward in the demand for bonds). The result is a reduction in bond prices and a rise in the interest rate. The stronger is the growth of the US economy in the near-term, the more likely is this increase.

But there is a lot more to the story. And this is where we get into money and monetary policy. We all know that the Fed, the ECB, and other central banks have pumped a lot of liquidity into markets. This means that bankers have a lot of money around and have received it at a very low cost. Thus, there is much money around so that when firms and governments sell more bonds or otherwise demand more credit, the banks and financial institutions will be able to meet this need without much increase in interest rates. But that is only half the story. If the economy does begin to improve and if central banks are worried that they may have overdone this money thing – then it will be time for them to be withdrawing all this cheap money from the system. This is interesting but not funny. This is interesting because we don’t know how markets will react. 

There is a bunch of money out there but the market might worry that the central banks will be too eager to remove the potent liquid from the boiling pot. Central banks often remove money by selling the bonds they acquired in the last few years. If investors think the central banks are too eager – then this will produce an expectation of too little bond demand relative to supply and will lead to higher interest rates. That could derail the growth of the economy.

The other interesting part is that we might get higher interest rates if the market thinks the central banks are pulling too little liquidity out of the economy. Some folks will see the economy recovering and worry that there is just too much cheap money out there – this would stoke demand for goods and services too much and inflation would increase. A rise in the public’s expectation for future inflation will mean that the buying power of interest earned in the future at current interest rates will be less than hoped. Therefore there will be pressure on current interest rates to rise to ensure a better buying power in the future.

Very interesting – interest rates could rise whether the central banks increase or decrease liquidity in the system. That sounds like a forecast of rising interest rates to me. A resumption of economic growth means that bond supply will outstrip bond demand. The subsequent rise in interest rates will not be affected by central bank policy. Whether the Fed increases or decreases the supply of money it is bound to underscore the rising rate. Of course much depends on the apparent strength of the US and world economy. Right now there are signs of relative strength in some parts of the world (USA, Latin emerging markets, Asia) and not in others (EU, central European emerging markets). Much depends on how all this plays out. If Europe enters a significant recession in coming months, money will flow from the EU to the USA and that will help to keep US bond demand high and prevent interest rates from rising. But if US economic strength spills over to the EU and other parts of the world, then the interest rate increase scenario is hard to deny.