Marc Cuniberti The stock market sold off hard last Thursday and the reason is believed to be a spike in interest rates.
Although it is thought by many the Federal Reserve (the FED) controls all interest rates, they actually control only one part of the interest rate arena, called the Overnight Discount Rate.
This is the interest rate the banking sector pays to borrow money for overnight operations. These overnight loans are a mainstay of the banking system. Banks borrow huge amounts on a daily basis while other banks deposit excess money into the same pot. Think of this overnight facility as a huge octopus taking in money and handing it out every moment of every day, all to fund banking operations which keeps the economy functioning.
The rest of the global bond market however and its interest rate is not controlled by the Fed simply because it is worldwide and encompasses too much money.
Think of it as a much larger octopus which operates worldwide.
What is the bond market?
Bonds are simply IOU’s. There is a lender and a borrower like any other loan. The financial sector calls them by many names to confuse you. For example, when a city borrows money, it’s called a muni bond. When money is borrowed for a house, it’s called a mortgage. When the U.S. government borrows money, it is called a bond, a treasury or even a bill. No matter what the name, it is all just debt.
There are all sorts of bond markets, from corporate bonds to mortgage bonds and all types in between. Much of the world’s bonds are publically traded in the bond market.
Bonds pay an interest rate. The rate is to compensate the lender for loaning money. The riskier the borrower, the higher the rate is paid by the borrower to the lender.
The U.S. government might pay a very low rate to borrow money, while a financially strapped company might pay a higher rate.
Higher rates are also paid commensurate with how long the loan will be. The longer the loan, the higher the rate paid.
When things are calm in the world economies, rates remain fairly stable or may even fall. When investors becomes worried about something however, rates will generally start rising. When they rise quickly, it can signify the onset of a panic or at least the fact that something is spooking market participants.
A worrisome world or economic event that threatens the stability of the financial environment can cause rates to spike, but the most common cause for a spike is a concern that inflation will start to accelerate.
As detailed in a previous Money Matters article entitled: “Inflation” I detailed how the creation of too much money by a government can cause “monetary” inflation. Monetary inflation is the most insidious type of inflation and can be the most damaging to an economy.
Trillions of dollars have been created for the CoVid-19 rescue and bailout packages by the U.S. government and indeed governments everywhere. It is no surprise that because of this fact, the bond markets may be sniffing out coming inflation, and perhaps a lot of it.
Since inflation is the loss of purchasing power of a currency over time, when the bond markets think inflation is coming, rates rise, as lenders require higher interest rates to compensate them for the loss of purchasing power, which will be caused by that very same inflation.
When rates rise, investors fear that the copious amounts of money currently flooding into the stock markets will slow, money will become tighter (harder to get and more expensive to borrow), and that will eventually cause a pullback in stocks.
The stock markets therefore look ahead, and the selling begins. If the rate creep turns into a quick jump in rates, stock market sell offs can intensify, which is what might have occurred last week. Only time will tell if the event was a one-off scare, or the start of something more insidious.
Be careful out there.
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