The money market interest rate or “short interest rate” is determined by the ECB (European Central Bank). The capital market interest rate or “long-term interest rate” is determined by investors and borrowers. The direction of interest rates is usually the same. Inflation is an important driving factor: when inflation is high, the ECB usually increases short-term interest rates. The investor bases his return requirement on inflation.
What are the consequences of an increase in money market interest rates for:
- Liquidities: the returns in this category are increasing.
- Bonds: price depends on long-term interest rates, so has no direct effect.
- Shares: economic growth is slowing down, so bad news.
- Real estate: not much effect.
What are the consequences of an increase in the capital market interest rate for:
- Liquidities: the returns respond to short-term interest, so no effect.
- Bonds: unfavorable.
- Shares: investments are slowed down, money is more expensive, prices fall. Bonds are then even better and there is also substitution of shares for bonds.
- Real estate: less favorable.
The real interest rate is the interest rate after which inflation has been deducted. Nominal interest rate = real interest rate + (expected) inflation Yield curve: graphical representation of the relationship between the remaining average term and the effective return of different bonds from the same risk category. Instead of average term, duration (the extent to which bond prices change as a result of a change in capital market interest rates) can also be stated.
- Rising or normal curve; long-term interest rates are above short-term interest rates and market parties expect inflation to remain stable. Steep, then people expect an increase in inflation. Normal, because the interest increases the longer the period over which it is received.
- Declining or inverse curve; ECB keeps short-term interest rates high to combat inflation, recession expected.
- Flat curve; economy is balancing between growth and recession or the development of long-term interest rates is in anticipation of an interest rate cut by the ECB.
- Help with making better-informed decisions (comparing alternatives).
- Means for determining the level of the effective return on new loans to be issued (issue prices).
It is not the current structure but the expected structure that determines whether an investor buys bonds or not.