Katie Bearup and Aspen Moraif
You may have heard about the historic Dow plunge on February 8, 2018. This over 1,000-point drop was largely due to concerns about the bond market and inflation.
This graph shows the Effective Federal Funds Rate in the last 16 years, up to February 8, 2018. It is not seasonally adjusted. The Federal Funds Rate is the rate at which banks lend reserve balances to other banks on an overnight basis. The Federal Funds Rate is one of the most important interest rates in the U.S. economy because it reflects monetary and financial changes, which have an effect on the broader economy, in the sense of employment, growth, and inflation. The Federal Funds Rate captures the overall trend in interest rates across the entirety of the U.S. economy.
Since the 2008 recession, interest rates have been close to zero, however as seen in the graph, this is not historically common. The upward trend in interest rates that took place at the beginning of this month may be the end of “cheap money”, as Americans will have to pay more for mortgages and loans, and companies will have to pay more for their loans, cutting corporate profits.
In order to understand the volatility, we must understand interest rates, inflation and the bond market. Interest rates are the monetary sum a borrower pays a loaner as payment for borrowing their money. Interest rates and the price of bonds are synonymous, and many times interest rates are calculated by the price of bonds. However, interest rates and the price of bonds have an inverse relationship: if price of government bonds increases, then interest rates decrease, and vice versa, meaning increasing interest rates make bonds less valuable. Additionally, the more bonds issued, the price of bonds falls and interest rates rise.
Further, there are concerns about inflation. Inflation rates are unusually low given the overall growth of the economy. The federal reserve regulates inflation by raising interest rates. Many people bet on inflation rising, but if they are wrong and inflation decreases, then interest rates rise and the price of bonds decrease.
If interest rates rise then the cost of borrowing money will increase, meaning companies will have to pay more to borrow less. This will negatively impact company profits, as they will have to compensate for the increase in interest rates. Because of this, a rise in interest rates often means a fall in stocks, as stock prices will reflect this loss in profit by companies.