Making sense of direction and level of Short term interest rates

Strategy: Short term interest rates will tend toward the inflation rate plus the economic growth rate

There is always a great deal of discussion about interest rates, particularly US rates. Short term rates are set by governments and this can be a fascinating process to watch. The rates affect the economy and many of the markets.

The benchmark strategy helps to make sense of discussions about their direction and their level. It is a rough guide which is often missed by many commentators. With this rough valuation target, interest rates are easier to understand than most markets, where it can be hard to have a clue what the prices should be. Equities, the market that most investors concentrate on, do not have this kind of benchmark.

An interest rate is made up of the inflation rate plus a 'real' rate. That is, the real interest rate is what is left after allowing for inflation.

Interest rate
= Inflation + 'Real interest rate'

The economic growth rate is the percentage expansion or contraction in the economy with inflation stripped out. It can be loosely considered as the dividend paid by the economy in general.

Economic Growth rate
= Rate of expansion or contraction in the economy - Inflation

Rate of expansion or contraction in the economy
= Inflation + Economic Growth rate

Over time, the real interest rate moves towards the economic growth rate. In that way, the return from interest rates and the return from the economy in general, are equal.

In 2005, the short term rates in the US are 1%. When they start to rise, how far could they go? In the US in 2005, you may wish to target 4% because inflation was around 2% and growth was also around 2%. Add them and you get the target.

Rates had started moving lower worldwide and the question was, how far they could fall? Using the rate of contraction in the economy and the inflation rate gives you an estimate of the economic growth rate. As over time, the real interest rate moves towards this economic growth rate, using this simple strategy, you can have an idea how much further interest rate could move and in which direction.

As the level of interest rates are somewhat predictable, this benchmark strategy helps you to invest intelligently in the bond market.