If the demand for credit reduces, then so do interest rates. This is because there are more people who are ready to lend, sellers, than people who want to borrow, buyers. This means that borrowers, buyers, can command a lower price, i.e. lower interest rates.
When the economy is expanding there is a higher demand for credit so interest rates go up. When the economy is slowing the demand for credit decreases and thus interest rates go down.
This leads to a fundamental concept:
|Bad news (i.e. a slowing economy) is good news for borrowers as it means lower interest rates.
|Good news (i.e. a growing economy) is bad news for borrowers as it means higher interest rates.
Another major factor driving interest rates is inflation. Higher inflation is associated with a growing economy. When the economy grows too strongly the Federal Reserve increases interest rates to slow the economy down and reduce inflation.
Inflation results from prices of goods and services increasing. When the economy is strong there is more demand for goods and services, so the sellers and producers of those goods and services can increase prices. A strong economy therefore results in higher real-estate prices, higher rents on apartments and higher mortgage rates.
Also lenders naturally want to see a positive return on their money as their reward for lending it. This leads to the concept of the “real” rate of return. This is typically 3% per year. If inflation is 4 % per year, lenders will want to earn 7% per year on their money.
Likewise, if prices are rising rapidly, people are inclined to borrow “today’s” money so as to repay it with “tomorrow’s” money, which will be worth less.
Mortgage rates tend to move in the same direction as interest rates. However, actual mortgage rates are also based on supply and demand for mortgages.
There is usually an almost fixed spread between A credit mortgage rates and treasury rates. This is not always the case. For example, bank failures in the Far East in the late 90s caused mortgage rates to move up while treasury rates moved down as fearful investors fled to the safety of the treasury bonds and notes.
There is an inverse relationship between bond prices and bond rates. This can be confusing. When interest rates move up, bond prices move down and vice versa. This is because bonds usually have a fixed price at maturity––typically $1000. The bond will start off being sold for the face value, $1000 and at a set interest rate. If interest rates go down, then this bond will go up in price so that these bonds will remain fairly priced compared with current bond offerings. Obviously the longer before the bond matures for the face value, $1000, the greater the price premium will be to enjoy that higher than current yield for the rest of the bond’s term.
The inverse also applies. If interest rates move up, the bond seller will have to reduce his price to offer a similar yield to current bond offerings.