This is pretty straightforward story. The example that follows is much too simple, but it makes the point.
Suppose I bought a 10-year Treasury bond with a coupon yield of 2.38%–the going rate–for $1000 yesterday afternoon. For my $1000 I get interest of $23.80 each year for ten years plus my $1000 back at the end of the term.
Let’s say that the Fed raises short-term interest rates sharply this morning, in a way that makes the yield on the 10-year rise to 3.00%–completely unrealistic, but this is just an illustration.
After this happens, for $1000 I can now get a 10-year Treasury that makes ten payments of $30.00 per year–a total over the next decade of $62 more than on the 2.38% bond–in addition to return of my $1000 at the end.
How much is my original 2.38% -coupon bond now worth? Put another way, how much would someone else now pay me for it? I don’t know exactly …but it’s certainly less than $1000.
Hi, in the previous post, u mentioned rate hike coming out from negative real rate is the more dangerous type. Can u pls tell which periods do u refer to? Where can i get the real interest rate chart? Thx
Thanks for your question. Take a look at today’s post.
Actually, I think that rate hikes that come to stop economic overheating are the more dangerous ones for stock market investors.
As to the real interest rate, I’m not sure where you might get a chart. Maybe other readers have ideas. The Fed has a chart on its website shoing where members of the Open Market Committee think short-term interest rates will be over the next several years., but that’s the best I can come up with. It is clear, though, that with the Fed funds rate at 0 and inflation at close to two percent, real short rates are negative.