World Map for Stocks #01: What Exactly Is an Interest Rate?

“US long-term interest rates rose, and stock prices fell.” You often see this phrasing in the news. Even though the topic was supposed to be stocks, interest rates suddenly appear. I would like to start the first page of our world map with this term.

An interest rate is the percentage of interest paid when borrowing money. For example, if you borrow 1 million yen at an annual interest rate of 1% and pay it back in a lump sum after one year, the interest is simply calculated as 10,000 yen. You pay back 1.01 million yen, including the original 1 million yen. The annual rate means “per year.” The actual payment amount varies depending on whether you repay in installments, whether there are fees, and so on.

For the lender, interest is the compensation for lending money. We, as depositors in a bank, also receive interest based on the conditions. For the borrower, it is a cost; for the lender, it is income. Even with the same interest rate, the perspective changes depending on your position.

Why is there a price on lending and borrowing? 1 million yen available today and 1 million yen returned one year from now cannot be treated the same way. While it is lent out, it cannot be used for other things, and there is a possibility it might not be repaid. If prices rise, the things you can buy with the returned money might decrease. These are the reasons why interest rates differ depending on the borrowing period and the counterparty.

Even with savings, inflation is a concern. Even if the interest rate is 1% per year, if the prices of goods rise by more than that during the same period, the amount of money may increase, but the quantity you can buy will decrease. You cannot say you “made a profit” just by looking at the interest rate figure. I will cover this topic in a later article on inflation.

Even when the news mentions “interest rates,” it does not always refer to the same thing. There are deposits, home loans, corporate borrowings, and government bond yields. The people lending and borrowing, as well as the periods, are different. If you are buying a house, you care about the repayment amount; if you are a company wanting to increase equipment, you care about the cost of borrowing. If you are buying government bonds, you look at the yield expected at the time of purchase. When you hear that “interest rates have risen,” the first thing you want to check is which interest rate it is.

The Bank of Japan and the US Federal Reserve (FRB) strongly influence short-term interest rates through monetary policy. That influence also spreads to bank lending rates and other areas. This is because the ease of borrowing money relates to household consumption and corporate investment, which eventually affects the economy and prices. However, central banks do not decide every interest rate in the world one by one. Loan interest rates do not all move by the same margin the day after a policy change. The way the influence is felt varies depending on the bank’s judgment and the terms of the contract.

The “US 10-year Treasury yield” often seen in the news is the yield formed while government bonds issued by the US government are traded in the market. Market views on future prices, the economy, and future policy rates are involved in the movement. Even if the central bank has not changed the policy rate today, long-term interest rates can move if views on the future change. Policy rates and long-term interest rates are related, but they are not the same thing.

People who watch stocks care about interest rates because they affect both companies and investors. If a company uses borrowed money to increase equipment, the interest rate becomes part of the cost. If interest rates change, it can affect investment plans and future profit forecasts. For investors, if the yields obtainable from deposits or bonds change, what they seek from stocks might also change.

However, you cannot simply conclude that “stocks will fall because interest rates rose.” Sometimes interest rates rise because the economy improves and corporate profits are expected to increase. Unless you look at both the reason why interest rates moved and the outlook for companies, the relationship with stocks cannot be understood. I will think about this more carefully next time.

When reading news about interest rates, I want to check three things: What kind of interest rate is it? How long is the period for the money? And why did it move now? The headline “Interest Rate Hike” alone does not tell you these three things. Did policy change, or did future expectations change? Only after looking that far do I consider the connection to stocks.

Interest rates are the entrance to the road connecting bonds, foreign exchange, companies, and households. Instead of memorizing them as a single number, try looking at them as the “price” between the person lending the money and the person borrowing it. If you do that, market news should become a little easier to read.

Next time: “Why do stock prices tend to fall when interest rates rise?” I will extend the road from the entrance we looked at today to the stock market.

Reference Materials

Financial Services Agency: “New ‘Money’ Lessons”

Bank of Japan: “Long-term Interest Rates”

Bank of Japan: “How does monetary policy affect the economy and prices?”

Japan Exchange Group: “How Company Stock Prices Are Determined”

European Central Bank: “What are interest rates and what is the difference between nominal and real interest rates?”

US Securities and Exchange Commission: “Bonds, Selling Before Maturity”

Federal Reserve Bank of New York Staff Reports: “The Term Structure of Expectations and Bond Yields”

Disclaimer
The content of this article and this account is intended to provide information for learning about finance, economics, and how markets work. It does not recommend the purchase or sale of specific financial products and does not provide investment advice. It does not guarantee future market trends or investment results. Please make investment decisions at your own responsibility.

Outsider Trading Research
https://note.com/outsider_tr

This is a note operated by my investment mentor.

They are also my benefactor who gave me the opportunity to start investing and learn about stocks. I have learned many things from them, not only about investment knowledge but also about how to face the market, how to think about trading, and even when I was worried about life.

Much of what I will write in this note from now on, and the way of thinking at its root, is what I have learned from my mentor.

If you have read “World Observation for Stocks” and liked it, please take a look at my mentor’s note as well.

I am sure you will find something new to learn.