[David Waring]

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In our last lesson we learned about the business cycle, why it is important in trading, and how the government tries to influence the business cycle through something known as Fiscal Policy. In today’s lesson we are going to begin to learn about monetary policy with a look at one of its key components, interest rates.

Interest rates at their core are the payment that a lender requires from a borrower in return for lending them money, normally stated as a percentage of the amount borrowed. If for example a lender makes a loan to a borrower of $100 for 1 year at an interest rate of 6%, then the interest payment and therefore cost of that loan for the borrower is $6.

Interest is normally made up of the following components:

1. The Time Value of Money: Under normal circumstances most people would prefer to have $1 given to them today rather than that same $1 given to them 1 year from now. The reasons here include the fact that if you have the dollar today then you can put it to work and potentially increase the value of that dollar over the next year or you can go ahead and buy something that you want now with your dollar rather than having to wait a year. As this is the case a lender is going to expect to be compensated for not being able to use the money he or she lends for a set period of time.


2. Inflation Expectations: If prices are expected to be higher 1 year from now than they are today, then a lender of money is going to want to be compensated for that loss in value over the term of the loan.

3. How much Risk there is that a loan will not be paid back. If a lender, for example, is lending money to someone he knows very well, has lent money to in the past and been paid back, and the loan amount is much smaller than his or her income, then that lender is going charge a lower interest rate than he will to someone that is not such a sure bet.

As most of you already know people borrow money for a number of reasons some of the most common of which include:

1. To buy a house (something known as a mortgage)
2. To start or expand a business
3. To buy consumer products (with credit cards)

Because borrowed money makes up such a large percentage of spending in the US and many other countries, how easy and cheaply the general population can borrow money has a large effect on economic growth. As this is the case, in general when interest rates are expected to go higher (making it more costly for people to borrow and spend money) people will be expected to borrow and therefore spend less money, and economic growth will be expected to slow as a result. Because of this in general when interest rates are expected to rise the stock market will sell off in anticipation of slower overall economic growth.

Conversely, when interest rates are expected to go lower (making it cheaper for people to borrow and spend money) they will be expected to borrow and spend more money and economic growth will be expected to rise. In anticipation of higher growth the stock market will normally rally all else being equal.

To get an idea of just how much even small changes in interest rates can affect things consider this as an example:

The payment on a $500,000 Mortgage at an annual interest rate of 6% is $2998 per month.

If the interest rate is 8% instead of 6% however you now pay $3699 per month which is about $700 more per month, $8400 per year, and $252,000 in additional payments over the life of that same loan.

So you should now have a good understanding of not only what interest rates are but also the important role that inflation plays in not only making goods more expensive but also in the cost of borrowing money.

In our next lesson we are going to further our discussion on interest rates, monetary policy, and learn about one of if not the most powerful institutions in the financial markets, the Federal Reserve, so we hope to see you in that lesson.

As always if you have any questions or comments please leave them in the comments section below so we can all learn to trade together, and have a great day!

[rocketman7]

Dave,
Why would the mortgage interest rate go up when the Fed keeps lowering rates? Wouldn't that effect the 10 year treasury note as well?

rocketman7

[David Waring]

Originally Posted by rocketman7

Dave,
Why would the mortgage interest rate go up when the Fed keeps lowering rates? Wouldn't that effect the 10 year treasury note as well?

rocketman7

Hi Rocketman7,

Great question. In short how interest rates on longer term debt instruments react to cuts in short term rates by the fed depends largely on the markets anticipation of what affect if any that cut will have on inflation.

As we will learn about in upcoming lessons one of the ways that the fed can use monetary policy is by lowering short term interest rates or something which is known as the "Fed Funds Rate". The Fed Funds Rate is basically the rate that banks charge to one another for short term (normally overnight) loans.

Now often times and what the fed hopes for when doing this is that there is a direct correlation between short term rates and long term rates like you get on a mortgage. This is not always the case however because there are more things that must be taken into account when making a long term loan than there are a short term loan which primarily means long term inflation expectations which will effect future interest rates.

As we talked about in our first lesson on Fiscal Policy anytime the government tries to influence the business cycle it is a balancing act between their two stated goals of working towards full employment and price stability. So, as has happened recently, when the fed lowers the fed funds rate by increasing the money supply to try and create more demand they also have to worry about the other side of the equation which is a decrease in price stability or inflation.

Although there can be other reasons which we will look at in later lessons, normally when you see rates on longer term loans rise as the fed is cutting rates this represents an increase in longer term inflation expectations from the market as a result of the rate cut.

Here are a couple more links with more detailed information on the subject and stay tuned for a lesson from us on this coming up shortly.

The Term Structure of Interest Rates

What is the relationship between the discount rate and mortgage rates? (06/2002) relationship of fed funds rate and mortgage rates

Best Regards,
Dave

[rocketman7]

Thanks Dave, appreciate the info and links!

rocketman7

[dunda2001]

Hi Dave,

Good videos, keep them coming! Anyway, I just thought I'd put something back into the community after taking so much information out from it.

From a trading point of view interest rates are absolutely vital to the capital markets and in fact pretty much every other market. From your video the general idea is that as interest rates go up (there are various interest rates, but for the purposes of this post I will be referring to the official Base Rate) then markets in general will go down.

From an equities point of view, what we have is a higher interest rate and thus a need for a higher rate of return on investments for the investor/FI/businesses. If a project say for example, BA wish to expand by buying a couple of more Boeing 747s, and by using various appraisal techniques finds out that the rate of return on each investment (assuming constant rates of returns for simplicity) is 5%, yet the amount of loan required from a Financial Institution is say 6%, then the planes will not be bought and thus the project rejected. This is the same for all companies regardless of what they want to make and so we can see from an equities point of view how this will effect stocks and shares.

From a debt point of view, it is equally gloom. Take the government bond for example. As interest rates rise, people are more willing to put their money into the bank's savings accounts as opposed to investing them in government bonds as the yield is better due to the higher interest rate. This puts depressing pressure on the price of bonds as there is now a lot less demand, thus the inverted relationship between interest rates and bond prices.

Now back to the part where in general this is what happens, however if we go into slightly more detail we find that what usually drives market behaviour is not the actual interest rate, but rather the difference between the expected interest rate and the actual interest rate. For example, if people are expecting the Mervyn King to announce a 3 point rise in the Base Rate say from 5% to 5.75%, yet on the day of announcement what we get is a 1 point increase (to 5.25%) the market may exhibit a great sigh of relief and although interest rates have moved up, the market rallies anyway. This is akin to trading the reaction to news on the markets. For example, the recent rally in JPMChase was not due to good figures, but rather less than gloomy figures.

Hope this helps and adds another dimension into thinking about fundamentals before trading!!!

[David Waring]

Hi Dunda2001,

Thanks so much for the addition to the community here. I majored in corporate finance and I have to say that if one of my professors had been able to put how interest rates affect corporations and the economy as eloquently as you have below, it would have saved me a lot of long hours of trying to figure everything out for myself.

Best Regards,
Dave

[dunda2001]

Hi Dave,

No problem! Just giving something back to the community, it's what it's all about right? Not really a fair comparison as I currently read Economics at uni (albeit a little rusty after a year of placement work!) and macroeconomics, where interest rates are a major focus point, was one of my strongest areas!

If I can think of anything else that can help with other traders and trading in general I'll be sure to input, and that should go too for the rest of the community! The more we add the more we can learn from each other!

[David Waring]

Yep that's what its all about.

Thanks Again,

Dave

[Cristian]

Hi Dave,



Thanks for the video, I would like to know what's the formula behind the example with 500 000 usd mortgage; and theoretically the persons who lends money at an increase of interest rate, they doesen't win anything because the rise of interest rate has the purpose to protect people economies, but the persons who borrows money, they gonna lose, am I right?

[P-P]

Originally Posted by Cristian

Hi Dave,



Thanks for the video, I would like to know what's the formula behind the example with 500 000 usd mortgage; and theoretically the persons who lends money at an increase of interest rate, they doesen't win anything because the rise of interest rate has the purpose to protect people economies, but the persons who borrows money, they gonna lose, am I right?

Hey Cristian,

Your question was to david but u mind if i answer it for u.

The formula for Compound interest is simply -

Principal x (1 + [Interest Rate]) *to the power of* Number of years

Also, Theoretically the central bank will consider the fact of rising the interest rates usually at the top or the peak of the buisness cycle to cut down and put pressure on the inflation that is inevitable in any bull market.
Central banks purpose for this is to 'tap the brakes' of the economy before it goes out of control.
In the result of higher interest rates, people will have less money to spend and the supply of money will be 'tight' so to speak, ultimetly slowing down the economy. When that is embraced, then the central bank will start to consider to cut the interest rates and then this cycle will go on and on...

i didnt undertand your question in regarding to the borrower will lose eventually or something ?!?

would you mind if you explain it again,

Peter