Jan 27, 2010: Understanding Interest Rates

Earlier today, the FOMC decided to hold rates. The Bank of Canada also kept rates at all-time lows. Both countries hinted that rates would remain at these levels until at least the summer and possibly longer. As a trader, I highly enjoy FOMC meeting days. The volatility and opportunities that arise can be very profitable. I find that the average person is disengaged with interest rate decisions mainly because they believe it has little impact on their lives, but I want to show how this is completely inaccurate, and how everyday life relies a lot on the consequences of interest rate changes. Banking Rates Rates are expected to rise, eventually. The most logical impact it has on our lives would be interest rates at the bank. The cost to borrow would rise, as would saving account interest paid to you. Products such as mortgages, GICs, and lines of credits would move up. Currency Interest rates also impact currency. If Canada were to raise rates, savings products become more appealing to foreign investors, and they would buy up Canadian dollars to buy these products. As you know, increased demand increases the its value, like an auction. Currency affects the cost of our everyday goods from apples to zucchinis. Commodities The direct impact interest rates have on currencies also affects commodities. World commodities, such as oil, gold, copper, and pork, are all priced in US dollars. With all things being equal, a dropping US currency increases commodity values. For most of the world, this would offset, but for Americans, this means prices of goods will increase. Transportation, natural resources, and food costs would all increase. Bonds As I discussed earlier, rising interest rates make investment vehicles more appealing, and as a result, this would decrease the value of standard bonds. For those that have never heard the formula: Interest Rates up = Bond Prices down = Bond Yields up. To better understand this, let us use a bond worth $1000 paying 5 per cent coupon interest. If the interest rate rose above 5%, risk-free investment products would be much more appealing than a risky bond. Therefore, the value of the bond must decrease to attract investors. So maybe, the bond goes to $900, still paying 5 per cent coupon. For bond amateurs, the 5 per cent is not based on the value of the bond today, but the par value, which is usually $1000. So, 5 per cent x $1000 = $50 a year. So now, $50 interest/$900 paid = %5.55, where it was only worth $5. Bond traders will use this as well, trying to make money on the value of bonds. Stock Market Generally, rising interest rates will take the stock market down a little bit. This is because the cost to borrow funds to invest in the market increases. You may see sellers to cover money they have borrowed or even enter bond markets or risk-free investments. The above five examples are very simplified, and in reality, there are always other factors. In most cases, the reactions are very short term. Secondly, rising interest rates could be used to tame inflation or slow down an economy, which isn't always a bad idea, although it seems to have negative consequences.