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Influences On Interest Rates

First, a confession: Interest rates are unpredictable. But then, you knew that already. Fortunately, they're not entirely unpredictable. Good bets are possible.

But before discussing some of the factors influencing them, a few words about why you should care: Price-Yield correlation. Which means what, now? As interest rates rise, bond prices fall. When rates fall, prices rise. Common sense reveals the reason.

Suppose a $1000 bond carries a 5% interest rate, and therefore pays two $25 semi-annual interest payments. If interest rates rise to 7%, several things can happen.

Anyone holding that bond seeking to sell will be forced to offload at a discount. Current potential buyers can get 7% ($70 per year) elsewhere. (Assuming similar credit risk and maturity.) Second, the holder can experience pressure to sell, since they're losing the opportunity to make an extra 2% per year.

If interest rates fall, bond prices for existing or new issues rise. Run the same argument, just reverse the arithmetic.

So, predicting interest rate movements - both when considering a new bond purchase and when debating when or whether to sell - has consequences for determining real yields. (Current Yield = Annual Interest Amount/Current Price. For more accurate estimates, see the 'Calculating Bond Yields' article.)

Now, what causes them to move? Naturally, the answer is: many things, any one of which has its own set of complex causes. Let's simplify.

For good or ill, U.S. Treasury securities have a significant impact on general bond rates. Their rates in turn are influenced by (and made somewhat predicatble by) GDP (in Europe, GNI), CPI, PPI and a variety of other economic indicators.

GDP is the Gross Domestic Product, the total output of goods and services produced in the U.S. (In Europe, they have the good sense to calculate it per capita, in order to adjust for differences in population, where it's known as GNI, Gross National Income.)

Large unexpected changes motivate the Fed (the U.S. Federal Reserve Bank) to adjust short-term rates up or down. That change influences short-term bond rates, since bonds compete with other possible investments.

CPI (Consumer Price Index) is a measure of the average change over time in prices of a select group of goods and one of the major measures of inflation. (Unfortunately, it doesn't include the cost of food or energy, which is fine for those who don't need to eat, heat their homes or travel anywhere.)

Since (most) bonds are issued with fixed interest rates, actual returns over time have to be calculated by subtracting the influence of inflation. 8% sounds like a healthy return until 4% inflation is subtracted, reducing the annual net return to 4%.

A higher than expected CPI influences bond prices to fall and interest rates to rise.

PPI: The Producer Price Index, which measures the average change over time in the prices recieved by domestic producers of goods and services. Somewhat the flip side of CPI, this measures price change from the seller's perspective.

When higher than expected, PPI rises signal inflation, again causing bond prices to fall as interest rates rise.

Other factors influence rates, such as unemployment rates, housing starts (new housing construction begun) and others. How much any one (or all together) influence rates is an ongoing academic debate with more than academic consequences.

Nevertheless, certain trends stand out.

Interest rates on domestic bonds tend to move with Treasuries, and the 30-year mortgage rate on home loans historically runs about 1-2% above the yield on 30-year Treasury bonds.

When the Fed increases the Fed Funds rate, it does so by supplying short-term securities in the open-market. This tends to decrease the money supply, which increases short-term rates. Bonds with short maturities will therefore tend to have higher yields.

When the U.S. government borrows it does so by issuing longer-term Treasury bonds to institutional lenders. This tends to drive rates up on corporates, since higher risk instruments have to compete with the more low-risk Treasuries. (One available alternative is Eurobonds, since the European Central Bank tends to peg its rate a percent or more above the Fed. Competition is beneficial.)

How much any of these factors influences rates is best researched by studying the charts available via simple Internet searches. They don't provide certainty, nothing in investing does, but bets based on sound data are as good as it gets.