We all know interest rates are important. Central banks control interest rates, and lowering them can stimulate the economy. It feels like adjusting interest rates is the biggest move central banks make. But have you ever thought about why interest rates are so important? Are they determined by central banks or by the market? Why can lowering interest rates stimulate the economy? Why raise interest rates during inflation? What is the relationship between interest rates and the stock market? How does it affect exchange rates?
This is what I personally believe is the most important concept in the economy: interest rates. How do they actually work?
Interest rates are a huge topic, so today I just want to focus on the main points. Let's get the underlying logic straight, along with some concepts that are often confused. This will probably lead to more questions, which we can address later.
Interest Rate
Also known as interest, it's something everyone has come into contact with. For example, if the interest rate is 2%, you deposit 100 in the bank this year, and you will get 102 next year. If you want to borrow money from the bank, you borrow 100 this year, and you have to repay 102 next year.
You can think of interest rates as the time cost of money. This year's 100 is equivalent to next year's 102.
Why are interest rates so important?
Let's simplify the problem first. Let's assume that all interest rates in this economy are the same, regardless of deposits or loans, whether I, Xiao Lin, take out a loan or Elon Musk takes out a loan, whether you deposit for one year or ten years. All interest rates are the same.
Now, if I lower the interest rate from 2% to 0, assuming all other conditions remain unchanged, let's see what happens.
Everyone in this economy who has money in their hands will see that there is no interest. Instead of saving money in the bank, they might as well buy a house, a car, a bag, or invest, open an online store, or a restaurant. In short, they will save less, and increase consumption and investment.
At the same time, everyone sees that borrowing money has a zero interest rate, so companies will take out loans to expand production, recruit, promote, invest, etc.
Compared with when the interest rate was 2%, people will borrow more money, invest more, and consume more. Many people will take out loans to buy houses, and those who sell houses will have more money. People who sell houses will buy cars, people who sell cars will have more money, people who sell cars will buy bags, people who sell bags will give me money, people who sell bags will buy houses, and people who sell houses will have more money again. The whole economy will be more active. This will create a virtuous cycle.
So you see, by simply lowering the interest rate from 2% to 0%, everyone starts making money, everyone works hard, and everyone's life gets better.
So central banks around the world are well versed in this. If there is any trouble in the economy, they will immediately cut interest rates to stimulate the economy. For example, in 2020, the Federal Reserve was just about to raise interest rates when it saw the epidemic coming and immediately lowered interest rates to stimulate the economy. Not to mention Europe and Japan, which have already started to cut interest rates to stimulate the economy. They have been around 0% for more than 10 years.
So you see, the central bank is doing a good job, right? I'm cutting interest rates to stimulate the economy.
This is certainly not reasonable. Going back to the example just now, I actually only told half of the story. We just said that the interest rate dropped from 2% to 0, the overall economy became more active, the unemployment rate was lower, and everyone had more money. But then what?
Enterprises will find that there are more and more rich people, the demand is getting stronger and stronger, and the prices of the bags they sell should increase. Not only the prices of bags and consumer goods have risen, but also the prices of raw materials such as leather and machines. In the end, everyone's wages have also risen. This will lead to inflation.
Conversely, the effect of raising interest rates is also corresponding. It will curb the economy in the short term, and it will also curb inflation in the long term.
This is why the United States and Europe have recently seen high inflation and immediately started raising interest rates, or are preparing to start raising interest rates.
So you see, we have analyzed so much just now, in fact, we want to come to a most basic and most critical conclusion that you must know: lowering interest rates can stimulate the economy in the short term, which is what we often call stepping on the accelerator for the economy, But long-term will lead to inflation. Conversely, raising interest rates will tighten the economy in the short term, which is what we call stepping on the brakes of the economy, and will curb inflation in the long term.
Let’s take a look at some of the news we hear every day: the Federal Reserve raised interest rates by 50 basis points in May, the European Central Bank plans to start raising interest rates for the first time in July, the United Kingdom raised interest rates for the fourth time by 25 basis points to 1%, and the People's Bank of China began to cut interest rates in 2022.
What interest rate does the central bank control? Is it the 1-year/5-year/10-year deposit interest rate we usually see in banks?
Of course not. For example, if I want to get a loan from the bank to buy a house now, a 10-year loan, the bank asks me for an interest rate of 5%, why does it want 5%?
What's going on in the bank's mind? Let's break it down.
This is mainly divided into three parts. The first part is called the risk-free interest rate. Let's assume it is 3%. The second part is my, Xiao Lin's, risk premium, let's assume it is 1.8%. The third part is my profit, that is, the money I want to earn, let's say 0.2%. Add these together, and it is the 5% you see.
The profit depends on market competition and the situation of the bank. Xiao Lin's risk premium is calculated based on my financial status, income, mortgage, etc., and then through a series of complex models, to calculate the probability of my default, and how big the risk is. The greater the risk, the higher the premium. For example, the bank’s loans to Apple or the World Bank are very low risk, and the premium is very low.
The remaining risk-free interest rate is the foundation of the entire economy. All the interest rates you see in the market, your deposit interest rates, credit card interest rates, mortgage interest rates, the interest rates on bonds issued by Tencent, all of these are based on the risk-free interest rate. This is also the interest rate we usually discuss.
What is the risk-free interest rate? It is a completely risk-free, in other words, people who are sure to be able to repay the money, the interest rate they need for the loan.
In real life, the closest thing to risk-free is the government, of course, the governments of those larger economies that can be considered approximately risk-free. The interest rates corresponding to the bonds issued by these countries, such as Chinese government bonds, U.S. government bonds, Japanese government bonds, and German government bonds, can be approximately regarded as the risk-free interest rates corresponding to the currency.
You see, these government bonds can be freely traded in the secondary market, so there will be a corresponding price, and the price can be deduced back to the interest rate. For example, the latest U.S. 10-year Treasury bond price is 100.5312, and we can calculate that the corresponding interest rate is 2.814%. Of course, you don't need to know how to calculate it. This 2.814% is the interest rate on the 10-year U.S. Treasury bond, which is also the 10-year risk-free interest rate of the U.S. dollar.
So you see, every maturity of every currency corresponds to a risk-free interest rate, such as 30-year government bond interest rates, 10-year government bond interest rates, 5-year, 2-year, 1-year, 6-month, 3-month, etc.
We can plot these risk-free interest rates on a graph with time on the horizontal axis, which will form a curve, which becomes the currency's risk-free interest rate curve, which is called the Yield Curve.
So the core interest rate in an economy is not a number, but a curve. And this curve is the benchmark for the entire economy, the foundation of the economy.
Typically this curve slopes upward, meaning that long-term interest rates are higher than short-term interest rates. Sometimes you will see that in an economy, its medium- and long-term interest rates are lower than short-term rates, for example, the 10-year interest rate is lower than the 2-year government bond interest rate. This situation is called interest rate inversion, which is Yield Curve Inverted.
This yield curve is another topic, which we won't go into today.
But we just said that this yield curve is derived from bond prices, so bond prices are determined by the market, which seems a bit contradictory. Didn't we just say that interest rates are controlled by the central bank?
What interest rate does the central bank actually control?
It's definitely different for different central banks, but the general rule is that everyone will control the shortest term or relatively short-term interest rates.
For example, the Federal Reserve, the Bank of England, and the European Central Bank all control the overnight lending rate, which is the one-day interest rate. For banks, the overnight lending rate is the most critical. This is what the central bank is holding.
For example, after the 2008 financial crisis, the Federal Reserve controlled the U.S. overnight lending rate, the Fed Funds Rate, also known as the federal funds rate, between 0% and 0.25%. Recently, we have heard that the various interest rate hikes are also this one-day interest rate.
All other interest rates in the market are influenced through the government bond market or the MBS market, so it is not something that the central bank can directly control.
Although it cannot be directly controlled, the central bank discovered after 2008 that it is obviously not enough to just control the Fed Funds Rate. In a hurry, it started printing money itself and participated in open market operations in the market. For example, if it sees that the 10-year government bond interest rate is too high, it will buy some 10-year government bonds. If it sees that the 30-year interest rate is too high, it will buy some 30-year government bonds. If it sees that the loan interest rate is high, it will buy some MBS. Anyway, it will bring down all long-term interest rates. This is what we often hear about, quantitative easing (QE).
Take the Bank of Japan as another example. It is more direct. It directly tells you that it will spend unlimited money to ensure that the 10-year government bond interest rate falls to 0.25%. You can see that Japan is being forced to do this just to get a little inflation.
If we look at long-term interest rates such as 10 years/20 years/30 years, it can be said that in terms of direct correlation, whether the central bank raises or lowers interest rates has little impact on long-term interest rates. Conversely, quantitative easing or shrinking the balance sheet, QE or Taper, have a great impact on long-term interest rates.
The key to economic activity is the circulation of money. The core of the circulation of money is interest rates. The basis of interest rates is a risk-free yield curve. The central bank generally controls short-term interest rates, while long-term interest rates are determined by market supply and demand. The central bank can try to influence, but cannot absolutely control.
So the question is, what are the specific impacts of interest rates on our lives and the economy?
In fact, if you understand the theory I just talked about, you may be able to deduce it yourself.
Interest Rates and Inflation
The first is the relationship between interest rates and inflation. We just said that long-term low interest rates will lead to inflation. This is why as soon as the United States sees that inflation is very high, the market immediately expects the Federal Reserve to raise interest rates. And not just raise it step by step, by 0.25% at a time, but raise it by two steps at once, to 0.5%. The purpose is to suppress inflation in time.
You see, the U.S. inflation rate in April was 8.3%, but the market expects average inflation to be 3% over the next five years. So you can see that the market is still very chill, expecting that the Fed’s interest rate hikes will bring inflation down.
For example, Turkey’s recent inflation has soared to 70%. Why?
Of course, there are all kinds of internal political problems and U.S. sanctions, but one of the big reasons is that the Turkish president is very strange. He insists that interest rates are the root of all evil. We have inflation internally, but we cannot deal with it by raising interest rates. We should cut interest rates.
So you see, the relationship between interest rates and inflation is very obvious.
Interest Rates and Bonds
In addition to inflation, what else does interest rate have a very direct relationship with? Didn't we just say that those long-term interest rates are all derived from bond prices in reverse? Therefore, interest rates and bonds have a very direct relationship.
This is the identity in the bond price calculation. Interest rates fall, bond prices rise; interest rates rise, bond prices fall.
How to understand this relationship? You can think of it this way. Assuming interest rates rise, the government will be able to issue bonds at higher interest rates. Relatively speaking, the original low-interest bonds do not look so attractive anymore, so the demand will decrease and the price will drop.
Therefore, for bonds with the same maturity, the relationship between interest rates and prices is negatively correlated. This is an iron law.
However, the relationship between different maturities is not so direct. We just said that the interest rate is a curve. The central bank will control short-term interest rates, and what is more relevant to our lives may be medium- and long-term interest rates ranging from two to three years to two to three decades.
Long-term interest rates, we can regard them as the expectation of a number of short-term interest rates in the future.
So you see, the current U.S. mid-term interest rates are also rising, partly because the Federal Reserve has raised the overnight lending rate, the Fed Funds Rate, and on the other hand, it is also because the Federal Reserve Chairman, everyone expects him to raise interest rates resolutely to curb inflation, so mid-term interest rates will follow.
Interest Rates and the Stock Market
Well, what about the relationship between interest rates and stocks? How will raising interest rates affect the stock market? It's obviously not as clear-cut as the relationship with inflation and bonds.
Let me state first that I don't have any investment advice. Don't run to buy stocks just because you listened to me for two minutes.
Let's analyze it theoretically first. For example, if the interest rate increases now, both long-term and short-term interest rates, let's assume they all increase. What will happen?
First of all, all kinds of companies, whether listed companies or small companies, will see the cost of bank loans or bond issuance increase. The financing cost of the company has become higher, and the development of the company has been hindered. You can understand it this way. So it is bearish for the stock market.
Therefore, raising interest rates has a greater impact on or blow to those industries that rely heavily on refinancing. If a company's balance sheet is largely debt, especially short-term debt, raising interest rates will hit it hard.
Then from the consumer's point of view, we just said that the cost of borrowing for companies has become higher. For consumers, rising interest rates also mean higher borrowing costs. Our mortgages, car loans, and credit card loans have all increased in interest rates, making it more difficult. People will definitely reduce consumption, and overall demand will decrease. It is even more difficult for companies to make money. So overall, it is bearish for listed companies.
The impact on industries that rely more on loans will be even greater, such as the housing and auto industries, because the consumption of mortgages and auto loans will decrease, and the impact on these companies will be even greater. For general daily necessities, the relative impact will be smaller. You've never heard of anyone who needs a loan to buy toilet paper, right?
Then you can think about it from a valuation point of view. You think a company, its theoretical stock price should be all the cash flow it can generate in the future discounted to the present. Isn't this discount rate the interest rate? Once the interest rate increases, the discount rate will increase, which means that discounting future money to the present will be less valuable.
Therefore, from a valuation point of view, rising interest rates are also bearish for the stock market. You see, this kind of impact on growth companies must be even greater, because their profits are all in the back, far in the back. So once discounted, the value becomes even smaller.
The connection sounds very reasonable, but the impact in real life is minimal.
Another is the perspective of liquidity. You think raising interest rates will tighten liquidity in the entire market, and everyone will be short of funds in the short term, which is definitely bearish for the stock market.
The reason sounds a bit simple and crude, but it should be considered the biggest and most direct impact of interest rates on the stock market.
So you see, I have actually told you from four angles that raising interest rates will cause stocks to fall. What are you waiting for? Hurry up and sell U.S. stocks and buy A shares.
Wait. What I just said is just the first level of influence. The beauty of economics is that it is multi-dimensional, intricate, and intertwined. There are so many variables in it.
For example, we just said that raising interest rates is not good for real estate, but at the same time, raising interest rates usually occurs during periods of inflation. Because we just said that raising interest rates will combat inflation, and during periods of inflation, many people will choose to buy a house to combat inflation. So from this point of view, it is good for real estate.
So you see, this creates a contradiction. It's not that clear. You can see that in the U.S. and Europe over the past 30 years, during periods of high interest rates, real estate has performed relatively well on average.
The causal relationship in economics is actually not that difficult to understand. The trouble is that it is intricate. Everything is linked. Interest rates are a major force for macro-control. It affects the overall economy. But when it comes to every company, every stock, the factors that may affect this company and stock are far greater than interest rates.
The impact of interest rates on the economy is like the impact of the moon on the earth. You think the moon can affect the earth's tides and the earth's rotation. The impact is huge and powerful, right? But as an individual, you won't jump higher at night just because there is an extra moon in the sky. Because for an individual, there are thousands of factors that determine the height of your jump, and the moon's gravity is nothing. I don't know if you can get my wonderful metaphor.
Let's go back and say, so when the central bank announces that it will raise interest rates, it is usually bearish for the stock market. But after three months, or even less than three months, even three weeks or a week, it's uncertain whether the stock market will go up or down.
Therefore, you can't just rush into the stock market because you hear that interest rates are going to be cut. This is obviously not wise.
Of course, raising interest rates is good for some industries, that is, those industries that make money from interest rates, such as banking or insurance, because banks make money from the difference between lending and deposit rates. Therefore, when interest rates are particularly low, it is definitely not conducive to banks making money.
If you look at the relationship between bank stocks and 10-year Treasury yields in U.S. history, you can see that there is still some positive correlation.
I would like to add here that we said that interest rates have no direct impact on the stock market, but another term we usually hear, quantitative easing, is different. Quantitative easing has an immediate impact on the stock market.
For example, looking at the past 10 years, those who have implemented quantitative easing, Europe, the United States, and Japan, you can easily feel the stock market. We'll dig a hole in this topic of quantitative easing and talk about it later.
Interest Rates and Housing Prices
Well, what is the impact of interest rates on housing prices?
In fact, it is similar to the impact on real estate. First of all, when interest rates rise, the cost of borrowing rises, which is definitely bearish for the housing market. But as we just said, high interest rates are usually a period of inflation. If inflation persists, the stock market continues to fall, and many people's funds are invested in real estate, so this impact is good for real estate.
So, it is uncertain.
Interest Rates and Gold
Similar theories also apply to gold. High interest rates will increase the yield of bonds, which will cause funds to sell gold and buy bonds. So in theory, raising interest rates should cause gold and other precious metals to fall. You see, this is the relationship between gold and government bonds over the past few decades. Isn't it obvious that there is a negative correlation? So raising interest rates will be bearish for gold.
But similarly, assuming you are in an inflationary environment, especially in a U.S. dollar inflationary environment, people will buy gold to hedge against inflation. This is good for gold again.
Therefore, it is uncertain.
Interest Rates and Exchange Rates
So what is the impact of interest rates on exchange rates?
You can think of interest rates as the rate of return on investing in a country's currency. So if the Federal Reserve raises interest rates, the rate of return on the U.S. dollar will increase, and the U.S. dollar will be under pressure to appreciate. But exchange rates are not a matter of one country, but between countries. We have to look at relative interest rates. For example, if the U.S. dollar raises interest rates, if the euro raises interest rates more than the U.S. dollar, the euro will be under more pressure to appreciate against the U.S. dollar.
So from this point of view, we have to look at the interest rate differential. For example, the Federal Reserve is now raising interest rates, which means the U.S. dollar is raising interest rates, and the People's Bank of China is cutting interest rates, which means the renminbi is cutting interest rates, which naturally widens the interest rate differential, which means the U.S. dollar will be under pressure to appreciate against the renminbi.
So this is also a trend we have seen in the market recently.
Although interest rates are also a big factor affecting exchange rates, there are many factors that affect exchange rates. Let me give a few examples: for example, when the inflation rate is high, the currency is under pressure to depreciate; if there is a large trade surplus, that is, when there are a lot of exports, the currency is under pressure to appreciate; if the market confidence is sufficient, the currency is under pressure to appreciate. Of course, there are also government and central bank interventions, etc., which can all affect exchange rates.
These are some of the things I want to talk about about interest rates. It also took me a lot of time to sort out this framework. So in fact, I am very happy that you can hear this. Of course, I would be happier if you could give me a thumbs up.
Because I don't want to destroy the integrity of the entire beautiful framework, I didn't tell those ups and downs and stories. I don't know how everyone feels about it.