Rising Rates: Understanding Changes in Interest Rates

PGIM Investments
January 15, 2019

Navigating the fixed income market can be daunting for the average investor. Being able to explain how and why interest rates move can help your clients make better informed decisions about their investments.

The term interest rate can be a bit ambiguous. Headlines about rising rates often refer to an increase in the fed funds rate (the very short-term interest rate at which banks lend to each other) or an increase in longer-term U.S. Treasury rates. These rates and the differences between them are largely determined by economic factors.

 

Understanding the Factors That Drive Short- and Long-term Rates

In the U.S., short-term interest rates are strongly influenced by the Federal Reserve, which was created by Congress to provide a flexible and stable financial system. The Federal Reserve implements monetary policy by influencing money and credit conditions in the economy in pursuit of full employment and stable prices. When growth is slowing, the Federal Reserve may decide to lower short-term rates (i.e. fed funds rate) to help stimulate the economy. The expectation is that lower rates will promote borrowing, which in turn promotes spending and business expansion. Alternatively, if the economy seems to be growing too fast, creating high inflation, the Federal Reserve may raise short-term rates in an effort to slow down the economy. The higher rates make borrowing less attractive and are intended to reduce spending, which should help rein in inflation.

Long-term rates, conversely, are primarily influenced by long-term expectations for U.S. economic growth and inflation. So if inflation is high, for example, a bond holder would want to be compensated for the climbing value of the money they lent out. Long-term rates may also be affected by current long-term global market rates, which is a trend we are seeing today. While U.S. rates may seem low relative to historic averages, domestic long-term rates are currently well above those in other developed markets. As a result, U.S. investments are in high demand as investors around the world search for yield. This demand puts downward pressure on the long-term yields in the U.S.

 

Economic Factors Affecting Short-term and Long-term Government Rates

 

Short-term rates

Long-term rates

Driver

  • Federal Reserve
  • Monetary Policy
  • U.S. Gross Domestic Product (GDP)

Key Factors

  • Short-term U.S. Inflation Expectations
  • U.S. Unemployment Rate (%)
  • Short-term U.S. GDP Growth Expectations
  • Long-term U.S. Inflation Expectations
  • Long-term U.S. GDP Growth Expectations

External Factors

  • Short-term Global Inflation Expectations
  • Short-term Global GDP Growth Expectations
  • Long-term Global Inflation Expectations
  • Long-term Global GDP Growth Expectations
  • Current Long-term Global Market Rates

 

GDP is a monetary measure of the value of goods and services produced in a country’s borders. It is used to determine economic performance of a country.

Monetary policy is a tool used by a monetary authority to control the supply of money.

Fixed income investments are subject to interest rate risk, and their value will decline as interest rates rise.

 

 

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