Interest Rate Primer

Interest Rate Primer

This is a Quick Primer On Interest Rates and how to read the medium to long term economic outlook for many countries by looking at them.

The first thing to look at when looking into interest rates for any particular country (or corporation, for that matter) is to look at their credit rating.  Unlike an individual credit rating, governments (sovereigns?) and corporations are rated by entities like Moody's and S&P. 

To get a feel for the general economic outlook for the world, look first at the counties that are rated highest.  Germany and the US are generally rated AAA or AA+.  These are good ratings.  The interest rate on their bonds over the next few years can tell if the country, and the world economy, is expected to do well. 

If countries with good ratings are paying 1% to 3% in interest, it is an indication that it is easy for them to sell their bonds, and that is the key to this whole puzzle. If it becomes more difficult for a particular bond to be sold, the interest rate on that bonds will go up.  If the smart money starts going into stocks, or gets invested somewhere else, there is less money available to buy their bonds, and the interest rates will go up.  Conversely, if the global market is expected to do poorly, with no growth (or even a recession), money will move to the safety of bond markets and governments will be required to pay less interest to sell their bonds. 

In general, the interest rates for the next few years on German and US bonds can be used as a rough guide to world economic growth for the next few years.  Subtract 1% from the interest rate and look at what is left.  In the case of US 2 and 5 year bonds, currently the result is a negative number. This tells me that the outlook for the next 5 years or so is a slight negative growth (We are currently moving into another recessionary dip). Note that I am talking about real growth, not what is advertized.  The difference should be obvious if you have read my previous economic articles.  The nation has been in a very slow downward trend since 2008.

In looking at countries with "less than good" credit, again, a higher interest rate indicates investors are less willing to buy the bonds.  This could be looked at as a reluctance because the investors are not certain the government will be able to repay the debts. This recently happened as Greece defaulted on its debts earlier this year, and has happened with smaller government bodies around the globe, from time to time. 

Returning to the situation in countries with good credit, one of the most obvious harbingers of a coming recession is what is called an inverse yield curve.  This is when the yield on long term bonds is less than on short term bonds.  In good times, investors will buy short term bonds, believing in a short time they will be able to move their money back out of the bond market into stocks and things that will make them more money. In bad times, they will seek long term bonds to keep their money safe until the recession is over.  More people buying long term bonds means their interest rates go down more than short term bonds, resulting in an inverse yield curve.

Looking at sudden movements or trends in the interest rates can reveal market trends before the more obvious indicators do.  In May, yield on the 2 year US bond went up, as the yield on the 10 year US bond went down.  This tells me that people are moving money from shorter term to longer term bonds, out beyond 5 years.  It tells me that we are moving towards a dip in the economic climate that will last beyond 5 years.

Now, all of these observations and forecasts are based on what other investors see.  I don't have a crystal ball to look through, but rather, I look at this through the eyes of other people, and they don't really know the future either.  They do, however, collectively, have a much greater insight into what is happening behind the scenes and around the world, in economics than I would have myself.  I just use this technique to distill their collective knowledge and vision into something a lay person like myself can use.