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3 Forces Driving Interest Rates Higher


In the past two weeks, interest rates have gone up sharply, sparking turmoil in the stock market. To take one example, the rate on 10-year Treasury bonds went from 2.66% on Jan. 26 to close at 2.85% on Feb. 12.

The recent moves have brought key interest rates up to levels they haven't seen since 2014. If the Federal Reserve sticks with its current policy course, chances are that interest rates will go higher still.

Why Interest Rates Are Headed Higher

There are three main forces that will help push interest rates up in the US:

Federal Reserve Rate Hikes

Federal Reserve Quantitative Tightening Policy

Expanding US government deficits

Federal Reserve Rate Hikes

According to its latest public projections, the Federal Reserve is planning to raise interest rates three more times this year. If they follow through on these projections, the result will be a total increase of 75 basis points or 0.75%.

It's important to note here that the Fed's decision to raise rates only directly affects one specific rate that they set explicitly. This interest rate is known as the federal funds rate, and it is used when banks lend reserve balances to each other overnight. This is effectively the shortest term rate available.

Because it's so short term, the federal funds rate acts as a kind of floor for other interest rates in the US economy. Providing an overnight loan to another bank is viewed as virtually risk-free. The short duration minimizes uncertainty.

If banks or investors provide financing for any duration longer than overnight, they will typically demand a higher rate. This heightened interest rate helps to compensate them for the additional risk they are taking on by making a longer commitment.

Thus, by raising the interest rate floor in the US, the Fed's actions will push other interest rates up as well. Indeed, this is the intended outcome.

Federal Reserve Quantitative Tightening

In the wake of the 2008 financial crisis, the Federal Reserve embarked on an unprecedented policy known as quantitative easing.