When considering how enormously important interest rates are, this topic’s a lot easier to learn than you’d expect. There’s only four things to learn before you’ll be able to understand all that jargon on CNBC and start sounding smart when having dinner with friends and family.
The first is that interest rates are charged when borrowing money. This is intuitively simple if you’ve ever bought anything on credit or with a loan. If for example you don’t have enough cash on hand to buy a car, you borrow some money from the bank and pay them back over time with interest on top of that.
The second is that a bond is debt issued by governments and companies. For example, say the government needs money for a project. You, the investor, give the government $1,000 for a bond. The government uses the money for their project and pays you back with interest.
So now to apply this. The relationship to remember is that bond prices move in opposite directions as interest rates. To illustrate this imagine Spongebob and Patrick on a seesaw.
If every time you hear “interest rates” or “bond prices” all you can think about is Spongebob giggling as he seesaws up and down, then you’re on the right track!
An example of why this works:
Year 1: You buy a new bond at $1,000, it pays you a 5% interest rate.
Year 2: You see new bonds still cost $1,000, but now only pay a 4% interest rate. Since your old bond pays a higher interest rate than what a new bond would, someone would be willing to buy your old bond off of you for more than $1,000. The interest rate dropped, your bond price increased!
Understanding this relationship is important as financial news headlines will frequently give one piece of information about either interest rates or bond prices and expect the reader to know the other side.
The third thing to understand is how stock prices fit into this. Companies and their stock prices don’t strictly need low interest rates to succeed, but it does help. With a lower cost of borrowing, it is easier for businesses to invest in new projects which if successful will help them grow. In this way, stocks are the Squidward of the markets. Squidward is at his happiest when Spongebob is pushed down a peg a two.
If you’re having trouble keeping this straight, try this:
Spongebob is the title character and star, he’s the interesting one = Interest rates
Patrick is dull (mentally) and bond prices are dull in their own way (boring as hell). Spongebob and Patrick are friends and so they seesaw together.
Squidward is extremely emotional, his mood swings up and down regularly just as stock prices do. He’s happiest when Spongebob (interest rates) is down.
He also looks like a stock price chart when he dances.
The last piece to understand how all of this works is the US Federal Reserve, also known as the Fed. Fed members are appointed by Congress and are given the important job of maximizing employment and managing inflation. One of the most important tools the Fed can leverage is their ability to change interest rates to control the monetary supply in the United States.
How this works: When the US economy is in the shitter, the Fed “cuts rates” (reduces interest rates at which banks can borrow money from the government). Banks in turn then can lend money to companies and individuals at a lower interest rate. The thought being that when it’s cheaper to borrow money, more people will do so. When this borrowed money is used to start new business ventures or to buy new things, the economy recovers with the increase in economic activity.
This graph below shows the Fed interest rate. The shaded areas show the last two US recessions. The first in 2001 shows the aftermath of the bursting of the Dot Com bubble. The one in 2008 shows the aftermath of the housing crisis. In both cases you can see the Fed dramatically cut interest rates to try and spur economic activity. The area highlighted in Yellow on the right shows how interest rates were cut in response to Covid-19.
This brings us to today. In March 2021, the Fed has hinted inflation may be picking up. Since Covid took the world’s attention, the monetary supply in the United States has grown very rapidly, increasing by trillions of dollars. There’s a few different components to why this is happening but perhaps the easiest to wrap our heads around are the stimulus checks given to every American.
Trillions of new dollars in the economy, plus the potential for an explosive growth in economic activity once nationwide lockdowns end and Americans begin to return to their previous lifestyles could be a recipe for inflation.
A quick note on inflation. Do you remember what an ice cream bar cost as a kid? I’m a 90's kid and vividly remember getting full size ice cream bars from the ice cream truck for 25c. That same bar today costs $1 or maybe even $2 today. That’s inflation! A little inflation each year is not harmful to an economy, but too much inflation in a short period of time can be dangerous.
Imagine if that same ice cream bar costs $5 a month from now. And $10 another month from then. Unless your boss is also doubling your pay every month (lol) then you’re in some big trouble. At that inflation rate, you’d soon not be making enough money to put literal food on the table.
How inflation works: Inflation happens when supply grows. Remember that Charizard Pokemon card you could never find as a kid? It had a lot of value because of how rare it was. If the Pokemon Company printed enough Charizards for everyone, people just wouldn’t value them as highly. The same concept applies to currency.
One of the key characteristics of any good currency is that it’s in limited supply. Imagine for example that in Bikini Bottom, the currency was not dollar bills but cups of water.
Every fish and sponge and barnacle would be a billionaire. It would cost thousands of buckets of water for a Krabby Patty. And how exactly would you store it all in a bank? Bad times all around.
You may think this is a rather extreme example, and it is, but it’s not entirely unheard of. Zimbabwe saw hyperinflation that peaked from 2007–2009. The result was the printing of one hundred trillion dollar bills, that themselves eventually became worthless!
If inflation rises too much, too quickly in the United States, the Fed may feel compelled to raise interest rates to attempt to slow the economic growth and inflation. This is bad news for stocks and bonds.
That’s it! You now know enough to be dangerous out there. Use your newfound power responsibly!
Note from the author: I’m passionate about creating content that’s engaging, well researched, and filled with real life examples. If you found this article valuable, please consider sharing it with a friend, it’s the greatest compliment!
