Rising Rates: Understanding Changes in Interest Rates

Understanding how and why interest rates move can help us to make better informed decisions about our investments.

March 02, 2017

Navigating the fixed income market can be daunting for the average investor. As we covered in the first article in this series, Rising Rates: What it means for bond investors, changes to interest rates impact the value of fixed income investments. Understanding how and why interest rates move can help us to make better informed decisions about our investments.

The term interest rate can be a bit ambiguous. When you see headlines about rising rates, it often refers to an increase in the Fed Funds rate (the very short-term interest rate at which banks lend to each other) or an increase in longer-term U.S. Treasury rates. These rates and the differences between them are largely determined by economic factors.

When it comes to corporate bonds, the current rate on a U.S. Treasury bond of a similar maturity weighs heavily into what a company may pay, but their credit worthiness will also play an important role in determining their individual interest rate. The portion of their rate resulting from their credit is called (aptly) a credit spread. The credit spread is less sensitive to changes in interest rates but more sensitive to changes in market volatility.

 

Understanding the factors that drive short- and long-term rates

In the U.S., short-term interest rates are strongly influenced by the Federal Reserve, which was created by Congress to provide a flexible and stable financial system. The Federal Reserve implements monetary policy by influencing money and credit conditions in the economy in pursuit of full employment and stable prices. When growth is slowing, the Federal Reserve may decide to lower short-term rates (fed funds rate) to help stimulate the economy. The expectation is that lower rates will promote borrowing, which in turn promotes spending and business expansion. Alternatively, if the economy seems to be growing too fast, creating high inflation, the Federal Reserve may raise short-term rates in an effort to slow down the economy. The higher rates make borrowing less attractive, and are intended to reduce spending, which should help rein in inflation.

In the seven years following the financial crisis, the Federal Reserve kept short-term interest rates at zero as growth remained relatively low – the economy did not show enough signs of strength to require action. In the last meeting of 2015, however, the Fed did raise rates, and markets thought that this meant the start of a series of rate hikes. Market volatility and political uncertainty early in 2016, however, made the Fed hesitant to raise rates again, so it wasn’t until December of 2016 that the second hike came.

Long-term rates, conversely, are primarily influenced by long-term expectations for U.S. economic growth and inflation. So if inflation is high, for example, a bond holder would want to be compensated for the climbing value of the money they lent out. Long-term rates may also be affected by current long-term global market rates, which is a trend we are seeing today. While U.S. rates may seem low relative to historic averages, domestic long-term rates are currently well above those in other developed markets. As a result, U.S. investments are in high demand as investors around the world search for yield. This demand puts downward pressure on the long-term yields in the U.S..

With the new administration in place and market optimism seemingly high, the Fed is showing that it expects to make a number of rate hikes over the next few years. This same optimism sent longer-term rates climbing late in 2016 as well. While only time will tell how this interest rate cycle actually plays out, investors have already shown that they are very interested in investment solutions that help to mitigate interest rate risk.

Economic Factors Affecting Short-term and Long-term Government Rates

 

Short-Term Rates

Long-Term Rates

Driver

  • Federal Reserve

  • Monetary Policy

  • U.S. GDP

Key Factors

  • Short-Term U.S. Inflation Expectations

  • U.S. Unemployment Rate (%)

  • Short-Term U.S. GDP Growth Expectations

  • Long-Term U.S. Inflation Expectations

  • Long-Term U.S. GDP Growth Expectations

External Factors

  • Short-Term Global Inflation Expectations

  • Short-Term Global GDP Growth Expectations

  • Long-Term Global Inflation Expectations

  • Long-Term Global GDP Growth Expectations

  • Current Long-Term Global Market Rates

Source: PGIM Investments


GDP stands for gross domestic product and is a monetary measure of the value of goods and services produced in a country’s borders. It is used to determine economic performance of a country.
Monetary policy is a tool used by a monetary authority to control the supply of money.

Fixed income investments are subject to interest rate risk, and their value will decline as interest rates rise.

The views expressed herein are those of PGIM Investments professionals at the time the comments were made and may not be reflective of their current opinions and are subject to change without notice. Neither the information contained herein nor any opinion expressed shall be construed to constitute investment advice or an offer to sell or a solicitation to buy any securities mentioned herein. Neither Prudential Financial, its affiliates, nor their licensed sales professionals render tax or legal advice. Clients should consult with their attorney, accountant, and/or tax professional for advice concerning their particular situation. Certain information in this commentary has been obtained from sources believed to be reliable as of the date presented; however, we cannot guarantee the accuracy of such information, assure its completeness, or warrant such information will not be changed. The information contained herein is current as of the date of issuance (or such earlier date as referenced herein) and is subject to change without notice. The manager has no obligation to update any or all such information; nor do we make any express or implied warranties or representations as to the completeness or accuracy.

 

0302529-00002-00 Ed. 07/2017

Consider a fund's investment objectives, risks, charges and expenses carefully before investing. The prospectus and the summary prospectus contain this and other information about the fund. Contact your financial professional for a prospectus and the summary prospectus. Read them carefully before investing.

An investment in our money market funds is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although the funds seek to preserve the value of your clients investment at $1.00 per share, it is possible to lose money by investing in the funds.

Mutual fund investing involves risk. Some mutual funds have more risk than others. The investment return and principal value will fluctuate and investor's shares when sold may be worth more or less than the original cost. Fixed income investments are subject to interest rate risk, and their value will decline as interest rates rise. Asset allocation and diversification do not assure a profit or protect against loss in declining markets. There is no guarantee a Fund's objectives will be achieved. The risks associated with each fund are explained more fully in each fund's respective prospectus. Consult with your attorney, accountant, and/or tax professional for advice concerning your particular situation.

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