Interest Rates

Interest rates are the price of borrowing money and the reward for saving it. They influence almost every financial market: bond prices move inversely to yields, stock valuations depend on discount rates, currencies respond to rate differences between countries and commodities react to financing costs and growth expectations. Central banks set short term policy rates, while markets determine longer term rates based on expectations, inflation and risk. Understanding rates is essential for any trader.

Types of interest rates#

See Central Banks Explained and Treasury Bills, Notes and Bonds.

Nominal vs real rates#

real interest rate ≈ nominal interest rate - expected inflation

Real rates matter most for asset prices. A 5% nominal rate with 2% inflation (3% real) is tight; a 5% rate with 8% inflation (minus 3% real) is very loose. See Inflation.

How rates affect markets#

How central banks influence rates#

• Policy rate changes directly affect short term borrowing costs.
• Forward guidance shapes expectations for future rates.
• Balance sheet policy: buying bonds (quantitative easing) lowers long term yields; shrinking holdings (quantitative tightening) does the opposite. See Quantitative Easing and Tightening.

Market pricing of future rates#

Traders read expected policy paths from:

• Fed funds futures and SOFR futures, which imply the probability of rate changes at each meeting.
• Overnight index swaps (OIS).
• The 2 year Treasury yield, which closely tracks expected policy rates over two years.

Tools such as CME FedWatch translate futures prices into meeting by meeting probabilities.

The neutral rate#

Economists talk about the neutral interest rate, the rate that neither stimulates nor restrains the economy, sometimes called r star. It cannot be observed directly, and estimates vary. Whether policy is above or below neutral shapes expectations for growth and inflation.

Historical context#

US policy rates were near zero after the 2008 crisis and again in 2020, then rose to 5.25% to 5.50% by 2023. In the early 1980s, under Fed Chair Paul Volcker, the federal funds rate exceeded 19% to break high inflation. Long periods of low rates in the 2010s supported high valuations for stocks and bonds.

Frequently asked questions#

How do interest rates affect stocks?#

Higher rates raise discount rates and borrowing costs, which tends to lower stock valuations, especially for growth companies with distant cash flows.

What is the difference between nominal and real interest rates?#

Nominal rates are quoted rates; real rates subtract expected inflation and show the true cost of borrowing or return on saving.

How can I see what the market expects for interest rates?#

By looking at fed funds and SOFR futures, overnight index swaps and short term Treasury yields, or tools like CME FedWatch.

Next, learn how central banks work in Central Banks Explained.