Wednesday, June 9, 2010

Why Interest Rates Rise

Interest rates of bonds are rising in the bond market. That means that people are more confident in the economy. Why is there this correlation?

The Federal Reserve Chairman Ben Bernake says he does not expect the US economy to fall back into another recession.

This boosts people's confidence in stocks and thus reduces the demand for safer investment instruments like bonds and treasury notes. In order to attract investors to bonds, the issuers of bonds thus need to raise the interest rate or coupon rate to make it competitive and lucrative enough for investors to invest in them. Otherwise, these investors would rather invest their money in the stock market.

Hope this provides a simple explanation on why interest rates rise when the economy is doing well.

Question:
As interest rates rise, can we also expect the interest rates or deposit rates in our banks to rise?

2 comments:

  1. Hi FF,

    How about this explanation?

    Confidence rise --> people buy stocks and sell bonds ---> bonds price drops ---> bond yield increase.

    Price and yield automatically adjust itself without the need of the issuers doing anything.

    Just thinking aloud.

    ReplyDelete
  2. Hi LP,

    Yeap. Your explanation sounds correct too.

    The reason the interest increases is because the price drops. Or is it because they increase the coupon rate?

    ReplyDelete

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