Understanding Interest Rates Impact

Macro 101: What’s R*, the real equilibrium interest rate? When setting interest rates, Central Banks aim to achieve price stability (and in some cases also maximum employment like the Fed). To do that, they need to calibrate rates around their interpretation of neutral: raise rates above this level if you need to cool down the economy and price pressures, and cut rates below neutral if you need to stimulate the economy. This is why Central Banks use the concept of r* or real equilibrium interest rate. R* is the estimated real rate at which the economy doesn’t overheat or excessively cool down. The chart below shows r* in the US is estimated to be around +1%, which means that if core inflation sits at target the nominal neutral rate would be 3%. Given inflation has been running above target for years now, the Fed is applying a somehow restrictive policy with Fed Funds at 4.25% (above neutral). But what are the inputs Central Banks use when calculating r*? 1) Demographics: a bigger labor force means stronger potential growth and a higher equilibrium rate and vice versa 2) Productivity: a more productive use of capital and labor implies a higher equilibrium Rate and vice versa 3) The availability of risk free assets: an ample supply of risk free collateral implies higher equilibrium rate and vice versa Yesterday’s Fed minutes showed some FOMC members believe r* has increased given the persistent use of deficits (more supply of Treasury collateral) and AI-driven productivity gains. This would make the Fed 4.25% rate not so restrictive as neutral would be seen higher at around 3.50%. What do you think? 👉 If you enjoyed this post, follow me (Alfonso Peccatiello) to make sure you don't miss my daily dose of macro analysis.

One of the biggest misconceptions in markets is that when the Federal Reserve cuts rates, bond yields automatically fall. The data tells us otherwise. Last year, the Fed cut its policy rate by 100bps. Yet, instead of declining, 10-year Treasury yields rose by 120bps. This disconnect highlights a fundamental truth: the Fed controls the short end of the curve, but longer-term yields are driven by broader forces — growth expectations, inflation dynamics, fiscal policy, and global demand for U.S. debt. For investors and businesses, the lesson is clear: lower Fed rates do not always translate into cheaper borrowing costs or higher bond valuations. Mortgage rates, corporate financing conditions, and government borrowing costs often move to the rhythm of the bond market, not the Fed. In today’s environment of persistent fiscal deficits, heavy Treasury issuance, and sticky inflation expectations, the bond market is asserting its independence more forcefully. The Fed may set the policy rate, but it cannot dictate how markets price long-term risk. For portfolio managers, this means risk management and allocation decisions must go beyond simply forecasting Fed moves. For policymakers, it is a reminder that credibility and fiscal anchors are just as critical as monetary policy in shaping financial conditions. Graph source: Bloomberg

Where do you think interest rates are going to go? Jamie Dimon has an idea. In his annual letter to JPMC shareholders, he indicates inflation is here to stay a while, and therefore, rates could go as high as 8% in the medium term. He said: "It is important to note that the economy is being fueled by large amounts of government deficit spending and past stimulus. There is also a growing need for increased spending as we continue transitioning to a greener economy, restructuring global supply chains, boosting military expenditure and battling rising healthcare costs. This may lead to stickier inflation and higher rates than markets expect." I can't argue with that. He has a point. Now, if you have to combat inflation, you need to raise interest rates. That isn't a risk-free move, as people in the CRE game know. Now what do you think happens if interest rates stay higher for longer? "A scenario where the federal funds rate hits more than 6% would likely entail more stress for the banking system and for highly leveraged companies... Rates have been extremely low for a long time, and it's hard to know how many investors and companies are truly prepared for a higher rate environment." This is a fantastic summary of our current moment. There is a lot of wishful thinking that interest rates will go back to the 2010-2022 period of QE and low rates. Many of the people trading actively in markets are under 37 and thus have no living memory of working on Wall Street when interest rates were not pressed down along the entire curve by aggressive Fed policy. For banks, for hospitals, for businesses - you need to incorporate scenario analysis into your annual financial plan. What if Fed Funds went to 6% and the 10y UST went to 8%? Would that break anything? Would you be prepared with a flexible balance sheet to absorb these rate changes and still operate normally? Considering this kind of extreme scenario in a relatively calm moment is a helpful exercise to allow organizations to position balance sheets for resilience and prepare necessary actions to take just in case. As financial planning gets underway at institutions this year, I think it's a very good idea to conduct scenario analysis to ensure you are protected. It's all about good risk management. Mr. Dimon claims JPMC is ready to thrive in any economic conditions: "While all companies essentially budget on a base case forecast, we are very careful not to run our business that way. Instead, we look at a range of potential outcomes for which we need to be prepared." Good advice. #fedpolicy #riskmanagement #interestrates

This is worth a read. The framework the RBNZ uses has similar shortcomings as it heavily relies on unobservable factors to generate forecasts and policy insights. Key weaknesses are the centrality of the output gap, neutral interest and exchange rate, and inflation expectations in driving assessment of the stance of policy. None are observable and must be assumed or estimated. Significant policy errors and reassessments result as we learn more about how these unobservable factors are developing. Output gaps that were once thought strongly negative with potential to cause low inflation with hindsight are found to be much smaller. Changes to estimates of the neutral interest rate are serially correlated through time - so an OCR once thought to be close to neutral is later revealed to be anything but. Forecasts of the OCR tend towards long run estimates that shift over time and are misleading. New Keynesian frameworks like that used at the RBNZ have been orthodoxy for a couple of decades. They have also been misleading over much of that time and have been unable to keep up with changes in the unobservable variables that drive them. I think this is a key issue now. There are two key concerns: 1) What level of inflation expectations is guiding decisions? We tend to use long moving averages of actual inflation combined with our inflation forecasts to estimate inflation expectations. More stable estimates are useful in times where we think expectations are anchored. But what if they aren’t? Using our forecasts of inflation, that assume anchored expectations, parrot back at us our priors as forecasts. If our priors are wrong then so will also be our forecasts and our policy assessment. We could easily be too sanguine about the inflation shock that’s just hit us. 2) How stimulatory is the OCR now? The RBNZ is using a neutral OCR of around 3-3.5% that’s conditioned on past lower estimates. It’s hence telling them that policy is modestly stimulatory now. But other factors point to a much higher neutral OCR estimate. Global norms for interest rates have shifted sharply higher. And we have seen much more persistent inflation in recent years than expected. Even with a supposedly negative output gap that should have driven domestic non-tradable inflation down below normal levels. Both observations point to a higher neutral OCR than appreciated. Inputting a higher estimate into the RBNZs framework will cause inflation forecasts to explode along with OCR projections. There’s no easy answers to these concerns. The best we can do is feel our way forward and reduce reliance on forecasts that could be overly reliant on our priors that may be wrong. https://lnkd.in/eyiwnMAs

The Impact of Interest Rates on Zambia's Bond Market 📊💰 In finance, few relationships are as important as the one between interest rates and bond markets. 📉📈 This connection is especially crucial for emerging economies like Zambia, where the bond market plays a vital role in government financing and economic growth. 🌍 Let’s explore how interest rates impact Zambia's bond market and the broader implications for the country's financial future. The Inverse Relationship 🔄 One of the fundamental principles of the bond market is the inverse relationship between interest rates and bond prices. 📉 When interest rates rise, the prices of existing bonds usually fall. On the flip side, when interest rates drop, bond prices tend to rise. ⬆️ This happens because older bonds with lower interest rates are less attractive when newer bonds offer higher yields. Thus, bond prices adjust to reflect these changes, influencing both pricing and investor sentiment. 💼 The Ripple Effect of Interest Rates 📈 Interest rate fluctuations directly affect bond yields, especially for new bonds. 🆕 As rates rise, yields on newly issued bonds increase to remain competitive, making them more attractive to investors. 💸 When rates fall, yields drop, causing bonds to become more appealing compared to other investment options. 💹 These yield adjustments play a crucial role in determining investor demand for Zambian bonds. Government Borrowing 💰⚖️ Interest rates heavily influence the Zambian government’s borrowing costs. When rates are low, the government can issue bonds with lower yields, reducing its debt servicing burden. 📉 This leaves more room for public projects and initiatives. 🏗️ However, when interest rates rise, the government faces higher borrowing costs, complicating fiscal planning and budget management. ⚖️ Balancing borrowing needs with manageable debt costs becomes critical in these situations. Investor Behavior 📊💡 Interest rate changes can shift investor behavior within financial markets. 📊 When rates rise, investors tend to prefer new bonds with higher yields, making these bonds more attractive than older bonds or riskier assets like stocks. 🏦 Conversely, when rates drop, investors may seek higher returns in stocks or other high-risk investments. 📈 These shifts in investor preferences affect the liquidity and demand for Zambian bonds. Navigating Zambia’s Financial Future 🚀⚖️ As Zambia continues to grow its financial markets, managing the challenges and opportunities presented by fluctuating interest rates will be key to ensuring the country’s financial stability and growth. 📊 💼🔍 The interplay between interest rates and the bond market will remain central to Zambia’s financial health. 🌟📉 ©️ Natasha Lloyd

Several of my followers have inquired about the administration's persistent efforts to urge Federal Reserve Chair Jerome Powell to implement substantial reductions in the Federal Funds Rate—potentially as much as 300 basis points in the near term. The primary rationale appears to stem from the structure of the U.S. government's debt portfolio, where a significant portion is comprised of short-term instruments. This creates ongoing refinancing needs, and lower interest rates would enable the Treasury to roll over this debt at reduced costs. To illustrate, the table below outlines the maturity profile of privately-held marketable U.S. Treasury securities as of March 2025 (the most recent detailed breakdown available; figures may have shifted modestly since then). As shown, approximately 35%—or over one-third—of this debt matures within the next 12 months, necessitating frequent refinancing. By advocating for aggressive rate cuts, the administration aims to facilitate the issuance of new short-term debt at lower yields, thereby mitigating immediate fiscal pressures. However, I view this strategy as inherently risky. Reliance on short-term financing exposes the government to potential liquidity challenges, similar to those experienced by financial institutions during the Global Financial Crisis of 2008. Should investor confidence wane—due to economic uncertainty, policy shifts, or market volatility—a refinancing crisis could materialize rapidly, with severe implications for financial stability. #Finance #Economy #Investing

It amazes me that someone can work in real estate capital markets for 10, 15, 20 years and still not really have a grasp of what drives the cost of capital. Working with a client on a 30 year DSCR loan on a 1-4 unit here in San Diego. He told me he's worried about financing it at 7-8% where rates are now since he sees the fed cutting rates and commercial loans are as low as the 5's now. He's expecting 30-year financing rates to reflect the current 5-year commercial financing rates. I didn't want to offend him but really wanted to explain to him that's not how it works. Different types of debt at different maturities have different drivers for the cost of capital, here's a few things to consider: 1. Although the Fed's policy rate is important in establishing market pricing for debt, the Fed only directly affects the shortest-term rates, with impacts further away on the rate curve typically being driven by many other factors that can overpower the FFR (e.g. inflation breakeven, term premium, economic growth). 2. Long-term debt like MBS and 30-year investor paper are measured against longer-maturity treasuries, so 5-year commercial paper is more in-line with the 5-year treasury, with MBS typically being measured against the 10-year. 3. An additional pricing consideration with long-term paper is the projected prepayment speed. The more rates are expected to fall during the term, the faster the prepayment. The faster the prepayment, the shorter the effective duration (average time to receipt of capital) is, making the debt behave/be priced more like shorter-dated bonds. Please drop a like or a comment if you learned something new or found this valuable and share any questions or insights you may have.

🌊 A Wave Of Refinancing Is Coming For Companies, And That’s A Risk If corporate profits have managed to resist crumbling in the face of soaring interest rates, it's because during the pandemic, companies took advantage of historically low interest rates and locked in dead-cheap financing. But that won’t last forever. As their current debt reaches maturity, companies will have to refinance. And that’s when we’ll really start to feel the impact of the higher interest rates. The Swiss-based Bank For International Settlements (BIS) has been thinking a lot about this and crunching the numbers. Here’s what it says: Smaller companies have a bigger and more pressing need to refinance: They’ll not only need to refinance sooner than their heftier peers, but they’ll also need to refinance more significant amounts – about 10% of their total revenues in each of the next three years, compared to less than 4% for major corporations. That means those bigger firms will have a sturdier shield against the headwinds of rising interest rates. US firms aren’t in a rush to refinance their debts just yet: Their debt maturity is spread out more evenly compared to companies across the other advanced economies, with the bulk of it due for refinancing in 2026-27. This is mostly because they rely more on bonds and notes, which typically have longer terms, rather than shorter-term loans and other borrowing methods. For companies in other advanced economies, the situation is more challenging: they have more immediate refinancing needs, with significant amounts of debt coming due for refinancing a lot sooner. Emerging market companies are most vulnerable here: They typically depend on bank loans, which often have shorter maturities, and so the refinancing challenges hit them a lot sooner. In fact, these companies are approaching their busiest refinancing phase in the next year, so if interest rates stay high, these emerging market companies could be the first to come under pressure. Now, refinancing at higher rates doesn’t have to be a calamity. But it does present a challenge: if their financing costs get pricier and an economic slowdown shrinks their revenues, companies might have to scale back their operations or accept much lower margins. More vulnerable ones – where interest payments eat up more of their revenue – could default. And this scenario could lead investors to demand higher risk compensation (higher interest rates for corporate debt), which would further hike financing costs for companies and intensify the strain. Historically, it’s in these conditions that stock markets struggle the most. So our hope lies in a resilient economy and lower inflation, where robust revenue growth and reduced costs help companies smoothly navigate through these refinancing challenges. But until all of that materializes, don’t ignore the risks. In financial markets, remember the wind often turns without a warning. For a lot more on the topic >> Finimize

Hedging Fixed Assets: Enabling Variable Benefits Through Swaps In the intricate world of bank treasury management, hedging strategies play a pivotal role in stabilising financial performance against market volatilities. One essential strategy involves hedging fixed assets, particularly through interest rate swaps, which can substantially shield a bank's balance sheet from interest rate fluctuations. Consider a typical scenario where a bank has substantial fixed-rate assets, such as long-term loans. While these provide a stable income stream, they also pose a risk should the interest rates rise, increasing the bank's funding costs. To mitigate this risk, banks often enter into interest rate swaps as a hedging mechanism. In an interest rate swap, the bank would agree to pay a fixed rate to a counterparty while receiving a variable rate in return. The crux of this strategy lies in the variable receive leg of the swap. This variable rate adjusts with market conditions, ideally increasing when the interest rates climb. Thus, if the bank's funding costs rise due to higher interest rates, the receipts from the variable leg of the swap also increase, offsetting or covering the heightened costs. This approach is not only conservative but also advantageous, as it aligns the bank’s income with its expenses in a manner that is both prudent and responsive to market conditions. By employing such hedging tactics, banks can better manage their asset-liability mismatches and enhance financial resilience. Understanding these strategies is essential for banking professionals who strive to ensure the financial health of their institutions in an unpredictable economic environment. Through such realistic and accurate risk management practices, banks can safeguard their operations and maintain a robust balance sheet.

The neutral cash rate has been defined by the RBA as “the level of the cash rate that would neither stimulate nor restrain demand; in other words, it would underpin a balance between demand and supply of goods and services and in the labour market, with inflation consistent with the inflation target.” The RBA noted in its February 2025 Statement on Monetary Policy that there has been a downward shift in some of its modelled estimates of the nominal neutral cash rate in Australia. We calculate that the average of the RBA’s seven models that estimate the nominal neutral cash rate put the current nominal neutral cash rate at ~2.9%. Such an outcome is materially below the RBA’s previous point estimate of the nominal neutral cash rate of ~3.5%. The downward assessment of the neutral cash rate more closely aligns to our thinking on where the neutral cash rate sits. The RBA Board should feel more confident to ease policy through 2025 based on its re-assessment that the neutral cash rate is lower than it previously assumed. #rba #monetarypolicy #australianeconomy #inflation #cpi #unemployment #wages #housingmarket Stephen Wu CommBank Business and Institutional