A Newton’s Cradle Analogy for Interest Rates
Tip: Although you are likely familiar with Newton’s Cradle, the popular desk ornament named after Sir Isaac Newton, a quick internet search for “Newton’s Cradle” may help you visualize the analogy presented below.
The monetary policy setting committee within the Federal Reserve (the Fed) directly controls only two interest rates, those being the Discount Rate and the Federal Funds Rate (FFR). The Discount Rate is the interest rate commercial banks must pay to access loans directly through the Fed, and the Federal Funds Rate is the minimum rate at which commercial banks can lend to one another in the overnight market. In this piece, we will focus on the impact of changes to the FFR as it is generally considered to be more influential in asset markets. The yield or interest rate attached to all other bonds or loans, whether they be US Treasurys, mortgage-backed securities, corporate bonds, home mortgages, bank loans, auto loans, etc., are influenced by adjustments to the FFR to varying degrees but are not determined directly by the central planners at the Federal Reserve.
To better understand how bonds of different credit quality (a measure of the bond issuer’s ability to repay outstanding debt with interest) and maturity (the term of the loan) are connected to the FFR, think of a gigantic Newton's Cradle with thousands of pendulums of various lengths. Each pendulum represents a different type of bond, and the length of any given pendulum is determined by the credit quality and maturity of the bond in question. Lower credit quality and longer maturity bonds are represented by longer pendulums. In this analogy, the FFR is the initial ball that is lifted and released, setting off a chain reaction.
Shorter pendulums, like the 3-month US Treasury Bill (a very high quality, very short maturity bond), are closely aligned with the FFR, moving almost in perfect sync with it. These shorter pendulums represent bonds with yields that stay closely tethered to the FFR. When the FFR changes, these yields adjust correspondingly with minimal lag.
Longer pendulums, representing long-dated bonds and/or those of lower credit quality (a 10-year BBB rated corporate bond, for instance), have the ability to swing much further and with greater variation in speed. These pendulums have a delayed and less predictable response to changes in the FFR, allowing the yields on these bonds to deviate more significantly from the FFR. Unlike in a traditional Newton’s Cradle, pendulums in our fictitious example can occasionally be influenced in the opposite direction of the initial ball (the FRR), meaning that the interest rate of lower quality and longer maturity bonds or loans can at times become disconnected from the direction of travel in the policy rate.
Despite the difference in the responses of bonds of differing characteristics to changes in the FFR, all pendulums are part of the same system and are ultimately influenced by movements of the FFR, just to varying degrees.
This analogy is meant to illustrate that when the monetary authorities reduce (or increase) their benchmark policy rate, it does not necessarily mean that all bond yields will immediately decrease (or increase) proportionally. While it would be our expectation for short-maturity and high quality bonds to see their interest rates to reprice in accordance with the FFR nearly immediately, on the contrary, the yields of bonds represented by the longer pendulums may initially swing further away before eventually stabilizing.
Hopefully, this Newton's Cradle analogy helps clarify how the price and yield of fixed income instruments of various types can react differently to changes in monetary policy. Lastly, I would like to offer my apologies to any physicists in the readership that may take issue with my limited understanding of the principles of conservation of momentum and conservation of energy!
Aaron
