Understanding the current phase of each interest rate cycle is the most important determinant of successful investing...

Interest rates make the world go round. They are the most effective tool of central banks for controlling growth and stabilizing prices. The core interest rate of any economy is the federal funds rate, which is determined by the local monetary authority (i.e. FOMC and ECB).

What is the interest rate?

An interest rate is the amount of interest paid as a percentage of the amount lent, borrowed, or deposited.

Key Takeaways

  • The federal funds rate is the rate at which commercial banks lend to one another and transact with the central bank
  • Banks are free to determine their interest rates for loans/deposits by considering the competition and central banks’ policies
  • APR is the annual percentage rate on a loan, typically noted annually
  • Most loans are based on simple interest, however, some loans use compound interest (more below)
  • APY is the annual percentage yield earned on a deposit account (such as a bank account)
  • The federal funds rate also affects the price of bonds. Interest rates and bond prices have an inverse relationship
  • A rollover or swap rate is the interest rate charged by a Forex broker for holding a currency position overnight (based on the interest rate differential between the two currencies)

 

 

Monetary authorities and interest rate decisions

Federal Funds Rate in the United States

The federal funds rate refers to the target interest rate set by the Federal Open Market Committee (FOMC). As mentioned above, this target rate determines how commercial banks lend their excess reserves to other institutions and borrow from each other. Using the FedWatch tool, we can get an idea of the future federal funds rate:

» The FedWatch tool

European Interest Rates and EURIBOR

The European Central Bank is responsible for adjusting the level of interest rates in the euro area. These rates apply to borrowing and lending between the ECB and commercial banks.

EURIBOR is a different rate, determined by the dynamics of demand/supply among commercial banks. This means that there is no direct involvement of the ECB.

» Current EURIBOR rates

LIBOR

LIBOR stands for London Interbank Offer Rate and is the world’s reference rate for unsecured interbank short-term borrowing. LIBOR is the basic rate for globally pricing financial products such as interest/currency rate swaps and mortgages.

» Current LIBOR rates

Balancing between price stability and employment

Monetary authorities adjust the level of interest rates according to what is happening in the economy. Their main goal is to balance between a) price stability and b) employment.

  • When the economy is overheated and inflation is booming, the monetary authority becomes ‘hawkish’ and increases interest rates. For the American FED, 2% is the long-term target for inflation.
  • When economic growth is weak and unemployment is high, the monetary authority cuts rates, or else it becomes ‘dovish’.

Apart from inflation, growth, and unemployment, many other factors are incorporated into monetary policy decisions. For example, industrial production, retail sales, producer price indices (PPI), and data from the general real estate market.

 

Calculating Simple and Compound interest rates

Most loans in the economy are based on simple interest, but some loans use compound interest. Compound means interest is applied to the principal amount and the accumulated interest of previous periods.

Calculating the Simple Interest Rate

The simple interest rate refers to the percentage of interest charged on an amount of money over a specific period.

The formula is as follows:

M = L * { 1 + ( R * T ) }

Where:

  • M = the sum of money to be paid after a specific time
  • L = initial loan
  • R = interest rate
  • T = time

Calculating the Compound Interest Rate

The compound interest rate incorporates not only the interest on the initial lending capital but also the interest from other periods. In comparison with the simple interest rate, the compound rate grows significantly faster.

The formula is as follows:

M = L * ( 1 +R ) ^T

Where:

  • M = the sum of money to be paid after a specific time
  • L = initial loan
  • R = interest rate
  • T = time

 

 

History of Interest Rates

The first central bank in the world was established in England (1694) with the mission of regulating loans and interest rates. However, the history of loans and interest rates began in antiquity. In ancient Mesopotamia, seed loans were made to farmers with the promise of paying back debts with interest during the spring harvest. These agricultural loans appeared later in the Code of Hammurabi, which declared an annual 33% to be the maximum interest rate a lender could charge.

During the Middle Ages, many European exploration endeavors were financed by loans. Genovese bankers financed the Spanish explorers. Additionally, by 1640, the Dutch provincial issued three types of debt:

  1. Promissory short-term debt
  2. Redeemable annual bonds
  3. Life annuities (death cancels the principal)

In 1752, the British Empire converted all its debt into one bond, offering a 2.5%–3.5% annual rate. In 1870, the US Congress passed an act authorizing debt issuing, which was later known as Treasury Bills. In 1927, Winston Churchill issued a 4.0% government bond to refinance WWI war bonds.

Chart: History of the world’s interest rates (5,000 years)

History of the world’s interest rates (5,000 years)..

 

Using data from the analyst @Macro_Tourist (2014), this is the short history of interest rates.

The 5,000-year history of interest rates

  • 3000 BC: Mesopotamia, 20%
  • 1772 BC: Babylon, Code of Hammurabi, 20-33%.
  • 539 BC: Persia, King Cyrus, 40+%.
  • 500 BC: Greece, Temple at Delos, 10%
  • 443 BC: Rome, Twelve Tables, 8.3%
  • 300-200 BC: Athens/Rome, 8.0%
  • 1 AD: Rome, 4.0%
  • 300 AD: Rome, under Diocletian, 15%
  • 325 AD: Byzantine Empire (Constantine), 12.5%
  • 528 AD: Byzantine Empire (Justinian), 8.0%
  • 1150: Italian cities, 20%
  • 1430: Venice, 20%
  • 1570: Holland, the beginning of the Eighty Years’ War, 8.13%
  • 1700s: England, 9.92%
  • 1810s: US, West Florida, 7.64%
  • 1940s: US, World War II, 1.85%
  • 1980s: US (Reagan), 15.84%

 

Interest rates of the past 50 years

In recent years, the Federal Reserve has focused on a 2.0% inflation rate while avoiding excessive monetary tightening. This is the history of U.S. interest rates since the 1970s.

Chart: History of US interest rates (50 years)

History of US interest rates (50 years)..

 

Final Thoughts

Interest rates move in cycles because the economy itself is cyclical. These cycles, between periods of expansion and contraction, are driven by a combination of economic factors. These factors include inflation, employment, and the growth rate of the economy.

Understanding the current phase of each interest rate cycle is the most important determinant of successful investing. Generally, financial markets move between two key phases:

  • a low-interest-rate environment, where capital markets and risk-on assets thrive
  • a high-interest-rate environment, where ‘cash is king and risk-on assets suffer

Understanding the two cycles can help investors decide when to invest and when to pull capital out of the markets. Each interest rate cycle affects all financial markets, including Forex currencies, equities, bonds, and even commodities.

 

Sources:

 

The History of Interest Rates

Giorgos Protonotarios, December 12th, 2023

for CarryTrader.com (c)

 

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