Few concepts in economics are so talked about and so often in the news, but at the same time so poorly understood, as interest rates.
Interest rates seem to involve lots of theory and more than a little guesswork about the economy, and even experts can't reliably predict what rates will do next. While all that may be true, nonexperts can gain a good basic understanding of interest rates by thinking about them in terms of supply and demand, specifically in the context of the Treasury bond market.
Simply put, interest rates represent the cost of borrowing money. When people talk about “interest rates,” they usually mean the general cost of borrowing money in the economy.
Interest in free market
Interest rates are important: low rates stimulate economic activity by making it cheaper for companies to expand and for people to buy houses and cars. Increased expansion and consumer demand result in more jobs. Higher rates discourage economic activity because they make such activity more costly.
Supply and demand refers to how prices are set in a free market. Prices are sensitive to supply and demand: when supply is greater than demand, the price typically moves lower. The opposite is true as well — if supply tightens, the price moves higher. For example, if the instability in Egypt were to spill over into its oil-producing neighbors and halt oil exports for a while (i.e., reducing supply), the price of oil would probably go higher in the U.S.
Supply and demand seem pretty straightforward as they apply to goods and services. It's just common sense that if everyone had the golden touch, like King Midas, the price of gold would probably go lower.
Interest rates, though, are intangible, and people don't buy and sell them in the ordinary way. They do, however, buy and sell assets that yield streams of earnings. The interest rate, or return on investment, is simply the ratio of annual earnings to the price of the asset.
So it's helpful to consider the Treasury market where, as in any market, supply and demand determine price and quantity sold. Understanding the relationship between a Treasury bond's price and the interest it pays is the key to understanding how supply and demand controls interest rates. A simplified primer on bonds is in order.
How bonds work
A bond pays a fixed amount of income each year, representing a fixed percentage of its face value: that percentage is its coupon, or stated interest rate. Assume that on day one of issue, that bond has a price of $100,000 and a coupon of 4 percent, meaning that the bond pays $4,000 per year in interest. If an excess of buyers pushes the price of the bond up to $125,000, then a new interest rate comes into play. This is called the current yield. The current yield is the percentage that, when multiplied times the new price ($125,000), equals the original yearly interest ($4,000). In this example, after the price increase the current yield is 3.2 percent (because 3.2 percent of $125,000 equals $4,000). So if the price of the bond goes higher, the yield goes lower in the same proportion. And if the yield goes higher, the price of the bond goes lower.
While current yields are lower, holders of bonds experience a capital gain. They can sell their bonds for much more than they paid for them. Bondholders are happy when interest rates are falling.
Let's apply this logic to 10-year Treasuries, which are the best proxy for interest rates in the economy. What could make the current yield on a 10-year Treasury move higher (as yields have, from about 1.5 percent a year ago to about 2.5 percent now)?
As we've seen, in a bond market, rising current yields mean that their prices have been going lower, because there has been more selling than buying (supply is greater than demand). But why would people be doing more selling of Treasuries than buying?
According to Robert Dauffenbach, associate dean and director at the Center for Economic Management and Research at OU Price Business College, there are numerous reasons why Treasuries can look less attractive to investors, prompting selling (supply) to outstrip buying (demand) and causing prices to go lower and yields higher. He points out that the Fed has been doing a lot of bond buying with its quantitative easing policy, which has helped keep interest rates low by supplementing demand for bonds, which in turn has supported bond prices.
But, queries Dauffenbach, “what happens when the Fed ‘tapers' its purchases?”
Bond demand reduced
Tapering purchases would mean reduced demand for bonds, which should make prices of bonds go down and yields rise, i.e., higher interest rates in the economy. In a rising interest rate scenario, bondholders experience lower prices for their holdings and their portfolios are worth less in the market. The Fed has been signaling reductions in future purchases causing distinct nervousness in the market for bonds.
Treasuries also look less attractive if investors become concerned about inflation, as they tend to shy away from fixed income in a rising price environment and instead favor investments, such as farmland, that are thought to better keep up with inflation. Or if investors think the economy is improving, and they sell Treasuries to reinvest in more risky, better-paying assets. Greater supply than demand could just mean that a large holder of Treasuries (like China) is selling.
How tea leaves work
This is where the tea leaves come in. While expectations of higher interest rates and higher prices may come to pass, they may just as well not. For example, the economy here or elsewhere could take a turn for the worse, causing people to put their money back into Treasuries in a “flight to safety.” Plug that into the supply/demand model: with more buyers (demand) than sellers (supply), Treasury prices will rise forcing their yields, and interest rates in the economy, back down.