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This article describes the impact of interest rates. A related concept is the Yield Curve. An interest rate is the cost of borrowing money. Among the many industries affected by fluctuations in interest rates, real estate and banking are perhaps the most directly impacted. When interest rates increase, borrowing becomes more expensive, dampening consumer demand for mortgages and other loan products and negatively affecting residential real estate prices. Rising interest rates can also lead to increased default rates, as holders of adjustable rate debt find themselves faced with higher payments. Vendors of mortgage backed securities, which consist of bundled mortgages, will see their ability to monetize the securities lessens as a result of the deterioration of the quality of the underlying asset. At any given time, there are a number of interest rates available in the economy. Interest rates vary across the size, risk, duration, and liquidity of an investment. The interest rates for various durations of investments (short- to long-term) are called the Yield Curve.
[edit] Why Interest rates Rise and Fall[edit] Money Supply and the FedInterest rates rise or fall largely as a result of the amount of money in circulation at any given time. The Federal Reserve Bank of the United States affects both short term and long term interest rates by manipulating money supply through open market operations or changing reserve requirements for banks. The former involves purchasing large volumes of government securities, in order to increase money supply (driving interest rates down) or selling large quantities of government securities in order to decrease money supply (driving interest rates up). The Fed can also raise the reserve requirement for banks, increasing the amount that banks have to hold against loans, and decreasing the amount that they can loan to the public. Two important factors affecting the Fed's decision to raise rates are inflation and the overall health of the economy. When inflation is too high or increasing too rapidly, the Fed may raise rates in order to slow the economy. Conversely when the economy is doing poorly the Fed may cut rates in order to promote stronger growth. Following the burst of the tech bubble in 2001, the Fed lowered rates dramatically. Years later in the face of an overheating housing market the Fed reversed course and raised rates continually through 2006. Since the last hike in 2006, interest rates had remained relatively steady, with the target federal funds rate (or the interest rate for consumers) hovering at 5.25%. In a surprise move, however, the Fed lowered its inter-bank lending rate (the rate at which banks loan money to each other to maintain reserve requirements) from 5.25% to 4.75% on August 17, 2007. This was meant to help offset poor conditions in the debt market by letting companies borrow money more cheaply; the Fed's goal was to stimulate economic growth without increasing inflation (which it feared an increase of the FFR would do). The Fed cut rates by another quarter point on October 31, 2007, to 4.50%, and trimmed another quarter point on December 11, 2007, lowering its target rate to 4.25%. On January 22, 2008, the Fed cut rates by a dramatic 75 basis points, to 3.50%, in a move that came between regularly scheduled Fed meetings in an attempt to stimulate the economy and reassure investors and consumers. At its regularly scheduled meeting just two weeks later, the Fed cut the FFR again to 3%.[1] Yet again, on March 18, 2008, the Fed aggressively slashed the FFR by 75bp to 2.25%.[2] Finally, on April 30, 2008, the Fed cut the FFR to a flat 2%, its lowest level in over three years. In response to the growing financial crisis, the Fed once again slashed the FFR to 1.5% on Wednesday, October 8th, the lowest level in over four years.[3] Additionally, central banks in the UK, China, Canada, Sweden, Switzerland, South Korea, Taiwan, Hong Kong, and the European Union all cut their target rates, as governments around the world attempted to restore investor confidence and boost liquidity in the markets. On October 29, less than one month later, the Fed voted unanimously to cut the FFR again, this time to 1%, the lowest level since 2003.[4] [edit] US Deficit and ChinaAlthough far from certain, there is speculation that the United States fiscal deficit can impact interest rates. The Deficit has grown from $5.8 trillion in 2001 to $8.5 trillion in 2006. In order to fund this deficit the government has to issue increasingly large quantities of debt. The government’s continuing demand for money has the potential to crowd out private investors, resulting in higher interest rates. In other words as the government borrows more money, there are fewer funds available to private investors, and as demand exceeds supply, interest rates rise. China limits the appreciation of its currency by using US dollars gained through its export activities to purchase US debt. By the end of 2006 China held over $649B in US debt. By providing the US government with a willing buyer for its debt issuance and paying for this debt in US dollars, China increases money supply and thereby lowers US interest rates. In recent months, however, both China and Japan have expressed concern about the size of the US deficit. Both countries have hinted that they may look to diversify their currency purchases further. A reduction in the amount of debt purchased by either country could have an impact on US interest rates. [edit] Companies that are hurt by rising interest rates
[edit] Companies that Benefit from Rising Interest Rates
[edit] Companies that Benefit from Wider Interest Rate SpreadsInterest rate spread refers to the percentage differential between the risk-free Treasury rate and the rate on other, riskier fixed-income securities. Companies that benefit from wider (i.e. bigger) spreads are:
[edit] References
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