The interest rate spread can often be used as an indicator of an upcoming recession in the U.S. economy and is a component of the Index of Leading Economic Indicators. The spread is determined by the difference between the short-term federal funds rate and the long-term U.S. Treasury Bond Yield.
Federal Funds Rate
One figure used to calculate the interest rate spread is the federal funds rate. The rate is the short-term interest rate a financial institution charges another to lend balances at the Federal Reserve overnight. A bank with surplus funds, for example, may lend some of its balance to another bank that needs more funds. The banks negotiate with each other to set the interest rate, and the weighted average of the rates among all institutions becomes the effective federal funds rate. While the Federal Reserve does not set the rate, the Reserve can engage in activity to reach a target rate set by the Federal Open Market Committee.
The other figure used to calculate the interest rate spread is the bond yield. Treasury bonds, which are issued for relatively long terms, finance the country's borrowing. A person who buys a bond is lending the money to the U.S., and in return receives interest. This interest is referred to as the "coupon rate." If you own a bond you can sell it before it reaches its maturity date, but at that time, the prevailing coupon rate may have changed. The bond price must be adjusted to reflect the current coupon rate. The bond yield is the financial return the bond owner receives, calculated by dividing the yearly interest rate payment by the current bond price. For example, if you buy a bond for $5,000 with a coupon rate of 10 percent, the bond pays $500 a year. If you want to sell the bond in the resale market when the prevailing coupon rate is only 5 percent, the price of the bond would rise to $10,000 so the bond yield would equal the prevailing interest rate.
Interest Rate Spread
The interest rate spread is calculated by the subtracting the federal funds rate from the yield of U.S. Treasury bonds with 10-year terms. As long as bond yields are upwardly sloping -- in other words, the bond yields increase as the time to bond maturity nears -- the interest spread is usually positive. If the bond yields begin to slope downward, the interest spread is usually negative. This occurs for several reasons. Interest rates usually decline during a period of economic recession. Bond investors may sell short-term bonds and purchase long-term bonds, such as 30-year bonds, to hedge against the effects of an impending recession. The selling off of short-term bonds lowers the bond price but increases the yield, while the buying up of long-term bonds raises the bond price and lowers the yield. If enough investors engage in this practice around the same time, the effect can create a negative interest rate spread.
The interest rate spread is an indication of what is happening, or is likely to happen, in various areas of the financial market. If investors fear a recession, the stock market is usually adversely affected. Financial institutions may change lending policies to head off potential problems. For example, if a recession is looming, mortgage lenders may tighten lending criteria to avoid incurring bad debt. The U.S. government may take action to try to prevent a recession if one is indicated by the interest rate spread and other economic figures. Conversely, if the interest rate spread is positive, investors and financial institutions might take on more risks because they believe the economy's outlook is healthy.
- Board of Governors of the Federal Reserve System: Open Market Operations
- Federal Reserve Bank of Cleveland: What Interest Rate Spreads Can Tell Us About Mortgage Markets
- Stanford University: Bond Yields
- Federal Reserve Bank of New York: The Yield Curve as a Predictor of U.S. Recessions
- The Conference Board: Global Business Cycle Indicators
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