Why do interest rates vary in different markets?
August 07, 2014
Q: Why do interest rates vary in different markets?
A: To answer this question, it might help to start with the components that make up interest rates, and then describe some of the things that cause those components to vary.
First, to get one factor out of the way, length is important in setting interest rates. The longer the loan or the bond, the more uncertainty there is about the future, and higher rates are generally the way that greater uncertainty is reflected. However, that does not account for differences in rates for instruments of essentially the same length. Market forces act on the various components of interest rates to create these differences.
The following are key components of interest rates:
- Inflation expectations. Any lender wants to get at least as much purchasing power back at the end of the loan as the principal was worth at the beginning. So, one component of interest rates is an amount intended to keep pace with the expected rate of inflation.
- Default risk. The less reliable the borrower, the greater the risk of default. Some component of the interest rate reflects the percentage chance that future interest or principal payments will not be made.
- Profit margin. The above two components are designed to make sure lenders do not lose money, but people do not lend money just to break even. Some component of the interest rate is designed to represent a profit after inflation and default risk are covered.
None of the above components is a constant, and here are some things that cause them to vary:
- Inflation environment. Expectations about future inflation are very much a function of the recent inflation environment, so at times when inflation has been low, interest rates will generally be low as well.
- Credit quality. The more reliable the borrower, the less of a default premium is needed. This is one reason why savings accounts that are backed by FDIC insurance generally have some of the lowest interest rates in any given environment.
- Economic strength. This is a supply-and-demand factor: The stronger the economy, the higher the demand for capital, so interest rates will be higher when the economy is thriving. Current mortgage rates and the interest on savings and money market accounts reflect the persistently iffy economy since the Great Recession.
Within any one nation's markets, the first and third of these factors will be pretty much the same across all issuers, so credit quality becomes a major factor in determining interest rate differences within domestic markets. When it comes to international markets, the inflation and growth environments can vary greatly from one country to the next, which is why interest rate differences can be especially large across national boundaries.
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