A Primer on Interest Rates and Market Impact

Matt Krupski  ISSUE 607 | JULY 2007

I've recently been asked what types of trading strategies to pursue when borrowing costs are being driven up, such as they have been recently. "Driving up borrowing costs" is just another way of saying increasing interest rates. Interest rate changes do impact various markets as well as you the consumer, and there are a number of fundamental factors you should know as a trader.

Interest Rate Futures/Treasury Products

The first thing you need to know as an investor or trader is that interest rates, or yields, move inversely to the price of Treasury instruments. So as rates increase, the price of Treasury bonds or Treasury notes goes down. Price and yields have an inverse relationship. The thing you must remember to determine is what the markets have already "priced in" as far as rate expectations, and what duration on the yield curve will be affected the most. Will long-term 30-year bonds, 10-year notes, five-year notes, two-year notes, or fed funds/ short-term rate contracts change the most? The Bloomberg financial service Web site is a good place to go to determine how the yield curve and interest rates are moving. Go to: http://www.bloomberg.com/markets/rates/index.html.

The yield curve simply represents various interest rates over various vehicles of different times. For example, are you looking at short-term, two-year Treasury notes, 10-year Treasury notes, or at the long end, the 30-Treasury bond. One more note on Treasury products. U.S. Treasury bonds and notes are regarded as a "safe haven" investment because they are backed by the government of the United States. In essence, you are loaning money to the United States, and it is paying you interest. The chance of the government defaulting is very, very, very small. (Note this is for actual Treasuries, not the Treasury futures, but the futures price and actual cash price are correlated.) Once the interest rate is high enough, people often will flock to Treasuries to take advantage of the high, "guaranteed" rate of return. There comes a point where people weigh the risk/reward of other investments and the rates consequently stop going up. As an investor, you might ask yourself, "should I keep my money in the stock market and hope to gain 8-10 percent with a lot more risk, or should I invest in Treasuries and get a guaranteed 5-6 percent?" As the guaranteed rates become more attractive and more people start buying Treasuries, their price stops declining and the rate stop rising. This is the "flight to quality" phenomenon people refer to.

Stock Index Futures

Let's examine how interest rates affect the stock market. The S&P 500 futures started 2007 around 1430, and the market has risen about 100 points so far this year. Once interest rates started moving up in early June, the stock market topped out. We often see a flight to quality when that happens.

If interest rates are increasing, money is becoming more "expensive" because of increased interest on loans. This lessens a company's ability to fund expansion projects, buyouts, etc. and to generally grow their business. In theory, this would hamper stock prices and send stock index futures down. In addition, higher interest on credit cards, mortgages, etc. would take a chunk out of the consumer's ability to spend while at the same time, encouraging more savings (due to the higher interest they could earn). Less consumer spending often translates to less profit for companies, and less profit means less incentive to buy a companies' stock. Less buyers = lower stock prices. However, sometimes the Federal Reserve increases interest rates because companies are doing too well--they're worrying about the economy overheating. If this is the case, then increased rates may not serve to turn the stock market down, but rather just slow the rate of appreciation.

The stock market is up more than six percent for the first six months of the year, and stocks are historically more risky than Treasury instruments. If you can get a guaranteed 5 – 5.25 percent in Treasuries versus keeping your money in stocks, you may decide you've made enough in stocks already this year, and interest rates are attractive enough to park your money in Treasuries. Again, that's the flight to quality people talk about–the highest quality, guaranteed investment—U.S. Treasuries. And that movement can dampen stock prices.

Foreign Exchange

Interest rates are also a big factor in the forex markets. If rates are going up in one country relative to another, than that country's currency becomes more attractive, and its currency should appreciate. This is the so-called "carry trade" you may have heard about. For example, if interest rates in the United States are significantly better than those in Japan, than one could borrow yen (where the interest charged on the loan is low), covert it to dollars and invest it in a higher interest bearing account/product, then convert it back to yen when the loan is due. However, as more and more people do this, the exchange rate between the countries adjusts to a point where it is no longer profitable to do this. However, if a country's inflation is high, its currency will be less attractive, because the actual value that currency can buy is decreasing. So if interest rates are increasing to combat inflation, that country's currency may not be as attractive.

Gold

Gold is typically considered another flight-to-quality investment because of its status as a hard asset. In an inflationary economy, gold is attractive because its supply is relatively fixed, and therefore should hold its value better than a currency. Another way to think of inflation is an over-abundance of currency. So if interest rates are rising due to inflation, then gold typically would appreciate. In my opinion, however, this will not happen right away. I think that as interest rates increase, people will first flock to interest rate products such as bonds or notes, to get "guaranteed return." This will bolster the U.S. dollar, as U.S. Treasuries have to be bought with U.S. currency. If inflation is increasing at a greater-than-normal or average pace (around 2.5-3 percent year), then people may eventually leave these instruments and look to invest into gold. If they are earning 6 percent on bonds and inflation is 4 percent, than they are really only earning 2 percent.

Housing Factors

There is one other important ongoing concern when discussing interest rates: the housing industry. Weakness in housing could exacerbate the whole economic situation. There are a lot of adjustable rate mortgages out there right now, and as rates go up, the payments go up. If consumers cannot afford their payments, they have to refinance their loan, sell their house, or risk foreclosure. As more people decide to sell or lose their house to foreclosure, the supply of properties for sale goes up. Of course, as the supply of properties goes up, prices (and consequently valuations of every home) come down. If valuations are coming down as consumers are trying to refinance their loans, they may find that they owe more on the loan than the house is now worth. A bank will not loan more money than the house is worth, especially if it is getting stuck with properties from foreclosures/defaults, and as more people are defaulting on their house, the bank will require a higher interest rate on the money it is loaning. So the situation can spiral into a worsening circle of foreclosures/increasing rates/declining values.

Interest Rate Outlook

The nation's central bank, the Federal Reserve, controls the Federal funds rate and the discount rate, which are short-term lending rates for banks. Currently, the Fed funds rate is at 5.25 percent. As borrowing costs for banks increase, they generally pass their increased lending costs to consumers and businesses, affecting loans of various durations.

I don't anticipate the Fed will change rates for the balance of the year. But if it does decide to do anything, I'd lean more toward an increase than a decrease in rates given the current economic conditions. The stock market has been resilient and keeps working its way higher, and the economy is humming along. A 5.25 percent Fed funds rate is not historically all that high, and in my opinion, is a comfortable rate for the Fed. I think that unless there is a real shock to the system, where we needed an inflow of funds to revive the economy, I don't see anything to justify a rate cut, even with the housing market on the weak side. People have already priced that in, and adjusted for it. There is some concern about pockets of inflation too. Crude oil is priced above $70 a barrel, and food inflation is becoming an issue. Not only has the need for ethanol increased the price of corn, soybean and wheat futures are trading at the top end of their historical ranges. That's all going to trickle into the economy

Of course, this is just some of the conventional wisdom and macroeconomic generalities in an economy with rising rates, and the markets could react completely differently. Please feel free to contact me to determine a more specific trading strategy you can consider, no matter which direction interest rates are headed.

Matt Krupski is a Senior Market Strategist with Lind Plus. For more information on this topic or others, he can be reached at 877-847-3034 or via email at mkrupski@lind-waldock.com.

Kristina Zurla Landgraf is editor of Lind eWire. She can be reached by email at editor@lind-waldock.com.

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