Rates, inflation and the dollar

One rate change, four ripples

Start with an existing fixed-rate bond. Its coupon stays fixed. If comparable new bonds offer higher yields, the older bond generally needs a lower price to compete; falling market yields tend to raise its price. For the same fixed cash flows, a higher price means a lower yield. Credit, liquidity and other terms also affect price.

Shares feel rates less directly but still feel them. Higher rates raise the cost of borrowing for companies and for their customers and tighten broader financial conditions, which slows investment and spending. Lower rates do the reverse. These are tendencies. Earnings news and other changes can outweigh them; a rate rise does not guarantee a fall in every stock.

Inflation is the third ripple. It reduces the purchasing power of fixed dollar payments; Investor.gov calls this inflation risk, because inflation erodes a fixed rate of interest. A fixed coupon does not itself adjust for inflation; inflation-protected securities have different terms.

The fourth ripple is the currency. A stronger dollar buys more foreign currency. With prices unchanged in the currency in which they are quoted, foreign goods cost fewer dollars and dollar-priced US goods cost more foreign currency. That tends to help US importers and pressure US exporters. A weaker dollar reverses these effects. Actual sales and profits also depend on pricing, demand and hedging.

The chain from a policy decision to the things this lesson tracks is stated plainly by the Federal Reserve itself: changes in the federal funds rate influence other interest rates, which influence borrowing costs for households and businesses and broader financial conditions; cheaper borrowing means more spending, which raises demand, which spurs hiring and can push wages and other costs higher. The Fed is equally plain that the linkages are neither direct nor immediate and that many other factors are at work — worth remembering when a question implies a rate cut mechanically produces a result.

The currency side has its own measured facts. The Federal Reserve publishes daily exchange-rate observations in its weekly H.10 release, taken as noon buying rates in New York, so a currency move is a real observable number rather than an impression. On trade, US sales abroad are exports, US purchases from abroad are imports, and the difference between them is the trade balance — reported for goods and services both together and separately, which is why a country can run a goods deficit and a services surplus in the same month.

Exam terms

Interest-rate risk

The risk that rising market rates push the price of an existing bond down.

Inflation risk

The risk that fixed payments buy less over time; also called purchasing-power risk.

Coupon

For a fixed-rate bond, the stated interest rate on face value; market yield changes do not reset it.

Yield

The return the bond gives at its current price; it moves opposite to price.

Exchange rate

How much of one currency another currency buys.

Strong dollar

A dollar that buys more foreign currency than it did before.

Worked example

A machinery maker sells two-thirds of its output abroad. Over one quarter, market interest rates rise sharply at home and the dollar strengthens against the currencies of its main customers.

1. Take the rate rise first. An existing fixed-rate bond generally falls in price when comparable market yields rise, holding credit and other terms unchanged.
2. The rate rise also raises the company’s own borrowing cost on any new loan, and it makes interest-bearing alternatives look better to investors than its shares. Both can pressure the share price, but other news may outweigh them.
3. Now assume its export prices stay fixed in dollars and there is no currency hedge. Foreign customers need more of their currency to buy those dollars, so the machinery costs them more in local currency.
4. The higher local-currency price may reduce export demand. A US importer buying foreign machinery at an unchanged foreign-currency price would instead face a lower dollar cost.
5. The conversion effect follows from the stated assumptions. Sales, earnings and share prices are forecasts, so distinguish likely pressure from a guaranteed outcome.

Check yourself

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Related practice

• Exchange rates and international factorsPractice this