Playing the game

Why is the future path of interest rates so interesting to the markets?

     Financial news services are forever printing statements such as *BOE'S KING SAYS UK DATA OVER COMING MONTHS TO DICTATE PATH OF UK RATES and the markets apparently react. So why is this of such interest to market participants? This essay looks at hopefully the salient points of interest in interest rates.

      As it happens, interest rates cater for inflation and for competition. If there was no competition, there would be no inflation, and there would be little need for interest rates. Without inflation I could store money for 10 years and expect to have the same purchasing power at the end of the 10 years that I had at the beginning. In practise this is not the case, and any money not earning interest risks missing a growth opportunity. This brings us to competition - for growth and to attract customers - for example to sweeten investors over opportunity costs of capital. The better the interest rate I offer, the more that investors are going to be attracted as customers to my schemes.

     The value of money depends on what people are willing to pay for it. If there are lots of projects requiring funding, then project teams will compete to attract investors by increasing the interest rates that they are willing to return to project financiers. Project financiers will also have minimum rates that they expect in return for their capital. The right balance of risk and return will win the funding. Without funding projects may not go ahead, yet without projects investors cannot invest their money. The two sides thrash out agreements and disagreements together, after all there are always both projects and investors out there.

     So why do central banks change their overnight rates, and why does this affect markets so much? Are the banks trying to control competition? Are interest rates used to deal with volatility caused by expected competition? It depends which market (FX, fixed income, equities or commodities) but there is some dichotomy between risk and reward, between investors and entrepreneurs, between shareholders and managers that often forces changes in asset prices when there are changes in overnight interest rates. Not only do the financiers and the project managers have different expectations, but then organisations - be they companies or countries - compete together for growth.

     So, four phenomenon - competition, volatility, inflation and interest rates - that we must be aware of in any trading and speculation experiments. Instead of the future path of interest rates, perhaps the question is about the future path of competition and volatility (hence the future path of inflation and interest rates) so... what? If we know this future path we can:

     In fact we can shift our attention to the most rewarding activities. The highest interest rate implies that either underlying inflation (or risk) is high, or that a government is trying to cool competition and volatility by increasing the value of money. Increasing the value of money will thin the demand for project funding because projects will have to perform that much better under competition to pay back the interest. Yet higher interest rates attract investors if the risk return ratio is competitive compared to other interest rates on offer. Why invest money in one place when another will do better?

     I have not really answered the question here in terms of experiments in trading and speculation. The future path of volatility implies that money will flow to where the risk to return ratio is most attractive. This depends on interest rates and the underlying ability to pay them. If there is competition for an asset (ie a rate of return) then the price of the asset usually increases. The speed of change depends on volatility. Volatility depends on the intensity of competition. What a government is looking for is a low volatility path so that intense change in conditions does not upset the population.

     The thing is that volatility is risky. Financially speaking higher risk requires a higher return in compensation. Though what is volatility for?

     My feeling on this subject is that interest rates are for managing future inflation, competition and volatility by setting a return on investment, where higher rates attract funds, and lower rates do not, depending on risk. Higher rates make a currency more attractive, but make a stock less attractive because of the risk premium. They have the same relative effect on fixed income instruments. They have different effects on different commodities, but that is a subject for another time.

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