The Relationship between short & long term interest rates

 

1-      Short term policy rates- These are the rates which are determined by Central Banks and on which all other market rates take their cue. They include such rates as federal funds and discount rate in the US, the bank rate in the UK etc.

2-      Short term market rates-These are market set rates and are closely associated with short term policy rates, such as the infamous LIBOR (An interbank rate), short Guilt rates  in the UK or Treasury bills (T-bills) in the US etc. These usually refer to anything with maturities from 1 month to one year. Depending on the quality of the borrower these rates vary from the most secure T-bills & short Guilts, where both governments are perceived as almost riskless having an independent Central bank and therefore the ability to print ad infinitum and the riskiest junk corporates or peripheral government bills the likes of Greece, Portugal, etc. So the less risky implies they converge closest to the Federal funds rate whilst the riskiest diverge the most. For example if rate expectations are neutral, 1 month T-bill rates will be almost identical to the overnight Federal funds rate whilst I month USD interbank rates will be at a slight premium to Federal funds reflecting the additional risk premium of first class banks.

The key is that the market sets these rates based on the costs of borrowing on the short term policy rates. So for example if the market feels the Fed will be tightening credit by raising the federal funds rate in 2 months’ time then 3 month T-bills will be trading at a rate higher than the overnight federal funds rate to a level closer to where the market thinks rates will be raised by the Fed. The opposite would also occur should the Fed be expected to lower rates in 2 months’ time. In other words the market tends to discount presently rate expectations based on the dynamic forces affecting these rates on a daily basis.

3-      Medium & long term market rates- The market refers to these as yields not rates anymore. It applies to maturities from 2 to 50 years known as notes and bonds. For any instrument whether it’s a Treasury or corporate note or bond  will henceforth be priced by the market by discounting presently the total of interest or coupon payments this instrument will have and thus the price of such instrument will vary on the basis of such discounts. Should short term policy rates therefore go up, ceteris paribus, the market will re-price presently existing T-notes or bonds to reflect these higher interest rates in the future too. In fact the longer the maturity the greater the changes in price for a given yield change. Moreover, long term rate or yield expectations are not only dependent on short rates but more importantly on all market forces which may have an instrumental effect on interest rates in the future. For example if the USD continues to fall in this current economic environment the market may perceive an expansionary effect by the increase in US exports and may thus begin to drive yields higher in expectation of a rise in short term rates in the future. The same would apply if the government embarks in a highly expansionary fiscal policy. These are just two examples but the variants are endless and yields will change by the effect each variable will have on perceived future economic activity.  

 

So in conclusion, long term rates are clearly associated with short term policy rates but because long rates are market determined they are also independent of them. A case in point would be if for example the Fed decided to raise short rates at this juncture. A likely effect would be a short term spike in long yields as the market feared the start of a longer term trend but may fall to a level lower than prior to such a policy decision as the market judges it premature and growth disruptive.

 

Thus a market related sustainable higher trending yield and thus yield curve is a sign of expectations of stronger growth as well as higher inflation. The key is for this mix to favor growth.