Right now there is essentially universal agreement that interest rates are going up. And this prediction holds for long-term interest rates as well as for the typically far-more-predictable short-term interest rates.

Do you know why short-term rates are typically more predictable than long-term rates?

It’s because those are the rates over which the The Fed, and more specifically the Federal Open Market Committee and its Chairperson, currently Alan Greenspan, has the most direct control. That control comes from some fairly complex nuts ‘n bolts sorts of things, but in essence comes down to The Fed’s regulatory authority over most of the banking system, and it’s ability to control the interest rates that banks charge each other for overnight loans.

Do you know why banks make overnight loans to one another?

It’s mostly because banks are required by various regulatory authorities to keep a minimum amount of their deposits on hand in cold, hard cash (or, in this day and age, in intangible, not-there-at-all digital information).

These cash funds on hand are know as reserves.

Having reserves, the thinking goes, makes the banks more stable and less likely to fold. Lack of reserves, people say, had a lot to do with bank failures during The Depression because, without reserves, the banks had s no cushion against failing borrowers.

* * *

Here’s how this reserves regimen works.

Say that Bank A makes a loan. In doing so, it has, in essence, exchanged some of its cash for the borrower’s IOU and maybe the borrower’s collateral agreement in favor of the bank, such as a mortgage. Now that IOU does not count towards Bank A’s reserves requirement, so, if Bank A was just barely meeting its reserve requirement before the loan, it might well fall below the reserve requirement after the loan, because in doing so it has exchanged its cold hard cash for an IOU.

So Bank A needs to add to its reserves before it closes up shop for the night. It needs to get some cold hard cash, and it needs to get it today.

So let’s say Bank A calls up Bank B, to see if Bank B has more than ample reserves, in which case it might be willing to exchange some of Bank B’s cold hard cash for Bank A’s IOU.

And let’s say that Bank B is flush, and is happy to loan Bank A some of its cash, so they do the loan. Bank A gets some of Bank B’s cash, bringing Bank A’s cash holdings up to at least its reserve requirement, and Bank B gets Bank A’s IOU.

Now the loan that Bank A gets from Bank B is usually a short-term loan because Bank A, if it is to stay in business, needs to have other cash coming in from depositors and from borrowers making payments back to the bank on the bank’s loans, so it is OK with not having the right to keep the borrowed cash long term. In fact, it would much rather replace Bank B’s cash with a customer’s cash deposited into a new savings account, let’s say, paying 0.25% (25 beeps).

And that’s how banks make a good deal of their money: they borrow short-term money (e.g. Bank A borrows short-term money from Bank B or from Bank A’s savings account customers) and lend out long-term money (e.g., as a 30-year mortgage to all of us).

As of this week, the short-term rate Bank A will pay to Bank B is 2%, and the 30-year mortgage rate Bank A might make carries an interest rate of about 6%.

Sounds like a nice business, doesn’t it? Bank A borrows $100k from Bank B at 2% and lends that same $100k out at 6%, which means that it makes 4% — often called a 4% spread — on the whole combined deal. And a 4% business is a pretty nice business, isn’t it, particularly if your 6% borrower gives you a mortgage to secure that 6% IOU?

* * *

But long-term rates are a whole different story. Long-term rates are set by the huge supply and demand pushes and pulls the world over. The Fed can try to move those rates, but those supply and demand pushes and pulls the world over are just absolutely gargantuan, so if The Fed steps into that market and tries to move interest rates by buying or selling long-term bonds from its portfolio, it is by no means assured of being successful in moving those rates.

For example, and thinking back to the interest rates up, bond prices down and vice versa rule, it the Fed wants to see long-term interest rates move lower, it necessarily wants to see increases in the price of long-term bonds (because the rule says, bond prices up means interest rates down).

So to get those prices higher it might start buying a lot of long-term bonds, which would, all other things remaining constant, increase the demand for long-term bonds, which in turn would tend to increase the price of long-term bonds and, voila, there you have it: long-term interest rates down.

And let’s take this a step further by assuming that those long-term bonds the Fed is buying happen to be U.S. Treasurys (yes, that’s how it’s spelled), which are long-term bonds issued by the federal government. Then, in that case, the net result of all this is that U.S. debt is being taken out of circulation.

So there’s less U.S. debt out there and lower interest rates. Sounds like the late 1990s, doesn’t ?

If, instead, the U.S. government is putting more of its debt out there, then it is increasing the overall supply of long-term bonds, which would tend to depress the prices of long-term bonds (over-supply drives prices down), which would mean higher interest rates.

Sounds like the 2000s, doesn’t it?

* * *

But the real wild card here is all the other suppliers and demanders of long-term money out there. And right now the biggest question mark is the demand of foreign governments and their central banks (their Fed-equivalents), and foreign investors en masse. How much do they want to hold long-term U.S. debt?

Well, that’s a hard call. Probably they want to hold less of it, especially as the dollar weakens relative to other currencies, because a weak dollar means that all dollar-denominated assets decrease in value to the extent the holder of those dollar-denominated assets envisions needing to convert those assets into assets denominated in other currencies. So that drives foreign demand down.

With less demand and more supply, prices should really fall, meaning interest rates should really go up.

* * *

But you know what? This soft of analysis has led people for the better part of this Millennium to say that long-term interest rates were going up, and going up right away. And you know what? They didn’t. They are pretty much where they were last year, right after they ticked up a bit after they swooned during the spring 2003 deflation scare.

So when there is pretty universal agreement that short-term interest rates are going up, they probably are. But when those same folks start telling you that long-term interest rates are going up, they are much more apt to be wrong.

You owe it to yourself

Thursday, November 11, 2004 at 9am
By John Friedman

This blog — which I’m thinking of as the FHB — is a week old.

In going back over the pieces, I see that an interesting phrase has come up more than a few times. The phrase is:

you owe it to yourself

Have you ever decided to follow up on something that you owe it to yourself to do? It can do you a world of good.

* * *

Let me be self-referential for a moment (aside: the FHB will strive to not be self-referential, one of the primary downfalls of many a blog).

I recently checked off an I owe it to myself item. It felt great.

I have never known much at all about the history of the Middle East. I didn’t know my Gazas from my Golans, I didn’t know the terrorists from the politicians, and I didn’t know whether you had to fly east or west to get from Iraq to Afghanistan.

And I wondered how much the whole thing had to do with things that happened thousands and thousands of years ago.

So last week, after the election and what with Arafat’s death being imminent and the knowledge that we were going to just stay the course in that mess of a war we started in Iraq, I decided that I owed it to myself to be at least a little bit smarter about all that.

So I rented a video called The Fifty Years War, which covers the Israeli/Palestinian situation from 1948 through 1998.

The video guy asked me why I was renting it. Because now, more than ever, that’s where the action is going to be, was my response.

And now, having watched the video (with some grains of salt) I know a lot more — I know that Gaza is land that Israel and Egypt have fought over, that the Golan Heights is land that Israel and Syria have fought over, I know that the difference between terrorists and politicians is often merely linguistic and seldom clear-cut, and that throughout history many politicians have been terrorists and many terrorists have been politicians, sometimes simultaneously and sometimes in succession, and I know that you have to fly east to get from Iraq to Afghanistan.

And, yup, I know that it all dates back to the time of Kings David and Solomon and the Philistines and the Assyrians, and to even before them — back to all those Old Testament players. Crazy cats all.

And now I know a lot more about why getting all those folks to just all get along is key to the peace of the entire globe. Key to peace for The Whole Shebang.

* * *

So what does that have to do with financial health?

Well, I reckon that at least a third of the people out there haven’t the foggiest idea about how they’re doing. They go about their days doing their money-in and their money-out, perhaps generating some savings here and there, maybe a little and maybe a lot, or perhaps generating deficits instead, maybe a little or maybe a lot, but all the while never really knowing up from down or in from out when it camed to the state of their financial health.

Those folks owe it to themselves to get smarter about all that.

Because, like it or not, our economic selves have a whole lot to do with our overall selves, right? So that being financially healthy usually plays a large role in our overall happinesses, doesn’t it?

In fact, it’s probably in the Top Five, don’t’ch’ya think?

In no particular order (or maybe in a very particular order?), there’s (1) having wonderful people in your life. There’s (2) having a body that is dependable and resilient and that does not constrain you. There’s (3) having hope for a better and better future for you and for all those you care about (which hopefully is every single living thing on the face of the Earth, as well as the Earth itself). There’s (4) many other things.

And in there somewhere is, as well, your financial health, which is a necessary but not sufficient component of your overall happiness.

Now how much financial wherewithal does it take to have financial health? That is very much an individual choice, and very much a matter of deciding what’s important, because bringing dollars into our lives often involves bringing other things into our lives that are not good for our overall happiness and jettisoning others that are.

But, surely, all of us have a point of financial health — a financial sweet spot that is something more than nothing and something less than everything — and, regardless of what that is, if you ain’t got it, then you and your overall happiness have a difficult road ahead of you.

So if you count yourself as being among those who do not know much about your financial health, then, please, you owe it to yourself to know. You owe it to yourself to know a decent amount about this all-important aspect of your life, to take the blinders off and see what there is to see.

You very well might be more financially healthy than you realize. But if you stay in the dark, you’ll never know and, if you never know, you can’t fix what’s broken and you can’t rest your laurels on what’s not, can you?

So, in this context, what you don’t know can most assuredly hurt you. And hurt you bad.

It can be done — I have seen it done many many times — without all that much effort. All you have to do is want to do it (often the hardest part) and then do it.

It’ll feel great. You’ll feel like you have some control that you didn’t have before. And that is something that makes just about everyone feel happier.

Of basis points, beeps and bips: the atoms of interest rates

Wednesday, November 10, 2004 at 10am
By John Friedman

Today I have something short and purely educational for you.

Interest rates are in the news today. Greenspan et al. are meeting, and there is unanimous agreement among the punditocracy that he will raise short term interest rates (the only interest rates over which he has much power) by 0.25%.

Now you might hear people call that last figure 25 basis points. That’s because, in the world of interest rates, a change in an interest rate of 0.01% can be quite noticeable, and therefore worthy of not being decimalized.

And that’s what a basis point is: it’s 0.01%.

And that means that 0.25%, being twenty-five times that slightest of percentage slivers, is 25 basis points.

You can think of a basis point as the atom of percentages, while 1.0% is the molecule.

This linguistic framework saves a lot of tongue-wagging, doesn’t it? After all, would you rather say twenty-five basis points or would you rather say twenty-five hundredths of a percent?

Pity those who are sibilance stressed, as even the best of British actor enunciators must have to work hard and concentrate fully when uttering the word hundredths.

You’ll often hear people say that a basis point is one one-hundredth of a percentage point. It’s fine to think of it that way. Doing so is, after all, accurate. But most people find it easier to think of a basis point as the smallest slice of an interest rate that is noticeable, and to keep it in mind that there are 100 of those smallest slices in each percentage point.

And some people like to think of basis points as a second iteration, in that percentages are all about hundredths, and basis points are all about hundredths of hundredths.

With time, all of this becomes second nature..

The common abbreviation for basis points is bps, as in 25 bps. If you’re talking about one basis point, I suppose you might see it shown as 1 bp., but I cannot recall ever seeing that.

The bps abbreviation has given rise to some interest rate jargoning, so that, interest rate jargoneers everywhere refer to a basis point as a beep, or as a bip, as in, Greenspan is raising interest rates 25 beeps today.

Now you, too, can sound like an interest rate punditor.

* * *

Quick question: many people know the rule that when interest rates go up bond prices go down and vice versa, but do you know why that is?

If you do not know The Vice Versa Rule, as I call it, and if you want to be smart about interest rates and bonds and such, you owe it to yourself to understand why it is so. Knowing that up/down rule is a start, but it is only that. To be smart in this arena you need to know the conceptual underpinnings of that rule.

But that is a topic for another day.