How Interest Rates Work in Capital Markets, rev 1.0

Related Materials

• Previous presentation: Smart Rebalancing Method
• Next presentation: Practical Details on Stock Pledge Loans at HSBC Hong Kong

Document Text

00416B Short: How Interest Rates Work in Capital Markets, rev 1.0. March 28, 2025, CLEC Investment and Financial Management Channel.

1. Central Bank Interest Rates and Open Market Operations

The central bank interest rate is the benchmark interest rate for banks to lend funds to each other. Banks often have long and short position issues. For example, a bank collects 10 billion yuan of funds today, but it may not be used for five days or more. Therefore, the bank will lend these 10 billion yuan of funds to other banks in the central bank's open market to earn short-term interest rates.

In addition, some banks need to make payments the next day or in the next few days, or someone applies for a loan and the bank needs funds to lend. But the bank's own funds may not come back for five or six days or longer. When short-term borrowing is needed, the bank enters the central bank's open market to borrow short-term funds.

Market lending between banks is mainly based on the central bank's benchmark interest rate. How does the central bank control the inter-bank lending rate within the benchmark interest rate range?

If bank funds are in short supply, the interest rate on open market funds exceeds the central bank's benchmark interest rate. For example, the current central bank interest rate is 4.75% to 5%. However, due to the shortage of funds, large demand for borrowing, and few banks with short-term funds, the interest rate will be pushed up.

If the market interest rate exceeds the central bank's benchmark interest rate range, the central bank will intervene through open market operations to release funds and reduce interest rates.

When open market interest rates are too high, the central bank will inject funds to increase market liquidity and lower interest rates;

When open market interest rates are too low, the central bank will withdraw funds, reduce market liquidity, and raise interest rates.

In this way, the interest rate will be adjusted within the central bank's benchmark interest rate range.

Banks can also deposit funds into central bank accounts and earn interest. Therefore, the central bank can use higher interest rates to attract banks to deposit funds into the central bank's accounts, thus reducing the liquidity of market funds.

2. Bank loans

When an average person or company borrows money from a bank, the interest rate must be higher than the central bank's benchmark interest rate. Because banks can obtain base interest rates by depositing funds in the central bank, and lending to individuals or businesses requires higher risks. Of course, the interest rate must be higher than the central bank interest rate. How much higher depends on the creditworthiness of the borrower.

3. Money market funds

Therefore, depending on your borrowing period, the risk-free interest rate is the central bank's benchmark interest rate or the ten-year Treasury bond rate, and general commercial loans may require a risk premium of more than 1% to 3% on top of the central bank's benchmark interest rate.

Therefore, general commercial lending interest rates are usually more than 1% to 3% higher than the central bank's benchmark interest rate.

3. Money market funds

Money market funds typically invest in short-term notes issued by large corporations. Just as short-term lending between banks is controlled by the central bank, large and creditworthy companies also have short-term funding needs and therefore use money market funds for financing.

Money market funds typically invest in securities with maturities of less than a year, so you'll see money market funds holding assets with maturities ranging from a few months to less than a year. Of course, the longer the bond is held, the higher the risk, the higher the risk premium, and the higher the interest. Therefore, the interest earned on a money market fund depends on the length and mix of short-term notes held by the fund.

4. U.S. Treasury Bills, Treasury Notes, and Treasury Bonds

The interest rates issued by the U.S. Treasury Department are determined by public auctions and market transactions. Central banks cannot control interference.

Therefore, when many internet influencers and financial-industry people say that central bank rate cuts will make bond yields fall and bonds surge, that is completely ignorant.

Central bank interest rates only affect the overnight lending rates between major banks.

The bond market interest rate is determined by the market. The longer the long-term bond, the more it is linked to inflation expectations.

Expected inflation plus a risk premium becomes the interest rate on long-term bonds; it has nothing to do with the central bank's short-term rate.

Treasury Bill (T-Bill)

A T-Bill is a short-term bond issued by the U.S. government to raise funds. The term of T-Bill generally expires in one year or less, and the common ones are 4 weeks, 13 weeks, 26 weeks, and 52 weeks. Because of its short maturity, T-Bills carry relatively low risk and are therefore considered a relatively safe investment option.

Treasury Note (T-Note)

When purchasing a T-Bill, an investor is purchasing at a discount and then receiving par value at maturity. This means you don't earn regular interest income, but instead make money on the difference between the purchase price and the face value. For example, an investor might purchase a T-Bill with a face value of $1,000 for $9.50 and receive $1,000 at maturity.

Due to its safety and liquidity, T-Bill is often used as a short-term cash management tool and is often considered an investment alternative to bank time deposits due to its relative safety. The interest rate is 0.1% to 0.2% higher than the central bank’s benchmark interest rate.

Treasury Note (T-Note)

The maturity of this kind of U.S. Treasury bonds usually ranges from 2 to 10 years, with 2, 5, and 10 years being the most common. T-Notes are purchased at face value, with semi-annual interest payments, and the face amount is paid at maturity.

Treasury Bond (T-Bond)

These U.S. Treasury bonds have longer maturities, usually 20 or 30 years. Like T-Notes, T-Bonds pay interest semiannually and pay the face amount at maturity.

These bonds have longer maturities and therefore generally offer higher interest rates than Treasury bills, but come with the risk of having funds locked up for a longer period of time and being more sensitive to interest rate changes. The focus is to be able to fight inflation, so interest rates will be linked to expected inflation.

For Treasury Notes and Treasury Bonds, with maturities from 2 to 30 years, auction yields are mainly determined by whether they can beat inflation and preserve capital. People will buy if the yield is expected to beat inflation. But because inflation is hard to predict over 2 to 30 years, there is an inflation risk premium. The longer the maturity, the higher the risk and the larger the premium. Under normal conditions, the yield curve beyond two years slopes upward.

5. Interest rate inversion

The interest rates of long-term treasury bills and treasury bonds mainly take into account long-term inflation, while the central bank's short-term interest rates take short-term inflation into consideration.

Therefore, when the central bank raises short-term interest rates in order to combat inflation, it will increase short-term (a few months to a year) interest rates, but long-term interest rates are usually not directly affected by the central bank's base interest rate. Therefore, there is actually no basis for saying that the central bank's interest rate cuts will lead to a decrease in interest rates on long-term bills and treasury bonds.

The central bank or the economy effectively controls inflation, making investors more confident about low inflation in the future, thus reducing the inflation premium and indirectly causing a slight decrease in interest rates on Treasury bills and Treasury bonds. But this is mainly due to investors' psychological factors, rather than directly caused by the central bank's benchmark interest rate.

Therefore, rather than saying that the decline in central bank interest rates affects long-term bond interest rates, it is better to say that the decline in inflation directly affects the decline in bond interest rates.

6. Current deposit and time deposit interest rates of general banks

The interest rate for ordinary people to deposit money in banks depends on the amount of funds in each bank. If some banks are strapped for cash and need more liquid cash, they will raise deposit rates to attract more depositors.

Therefore, you will often see some bank advertisements, such as depositing $15,000 and giving you a $200 bonus in 3 months, etc.

However, no matter how high the deposit interest rate is, it should not be higher than the central bank's benchmark interest rate. If a bank offers deposit interest rates that are higher than the central bank's benchmark interest rate for a long period of time, you should be careful, as the bank may be about to fail.

If it's just commercial promotions and advertisements that entice you to deposit money for up to a year, giving you high interest rates for the first few months and then returning to normal interest rates, this is just to attract your deposits. Usually, after a high interest rate, the interest rate will become a floating low interest rate.

The above sharing and suggestions are for your reference! I hope these suggestions will be helpful to your investment decisions. Keep a good attitude, keep learning and adjusting strategies, and wish you all the best! Welcome to share your thoughts and experiences in the comment area, thank you for watching and supporting!