Interest Rates

The interest rate is a product of the market. It is the outcome of the demand for money and supply. When interest rates rise, fewer people want to borrow money. If interest rates are high, people will have to pay more to access capital. Why does this matter for crypto? If interest rates are high, they reduce the borrowing rate, consequently lowering the demand for risk-on assets.

We split interest rates markets up into two markets:
1. The money market
2. The bond market

The money market is for short-term loans with maturities of < 1 year

The bond market is for loans with a maturity of> 1 year.

Money market instruments have shorter maturities than bonds. There are exceptions to this rule, though. Some money market instruments have longer than one-year maturities, whereas some bonds have shorter than one-year durations. This rule is not absolute; it serves merely as a guide.

Interest rates are determined via an auction between borrowers and lenders on the money and bond markets.

The general rule is that instruments on the money market are loans, and instruments on the bond market are bonds. How long it takes for the borrower to repay the lender depends on the instrument itself. We standardize that the duration of money market instruments is shorter than bonds. Interest rates are the agreed upon between borrower and lender. The borrower and lender determine the interest rate that will be paid.

The actions of governments and central banks also influence interest rates. Central banks impact short-term interest rates, impacting other market interest rates. This is because central banks want to influence interest rates to implement monetary policy. By altering interest rates, central banks determine the economic outlook.

For instance, if the central bank wants to stimulate lending and economic activity, it may reduce interest rates. That reduces the cost of borrowing money for companies, which should increase lending and investment. The central bank may raise interest rates to slow the economy. That increases the cost of borrowing money for businesses, which should discourage loans and investment. Therefore, central banks may indirectly impact the economy by altering interest rates. And because central banks significantly impact short-term interest rates, this also affects other market interest rates.

The most widely recognized view is that interest rates are negotiated in the market. That suggests that the market’s exchanges between buyers and sellers influence prices, with a security’s price being determined by supply and demand. However, with interest rates, governments, the federal reserve, and central bank policies significantly impact them. These institutions may influence and dictate the money supply, affecting interest rates.

For example, If the federal reserve wants to increase the money supply, it will print more. That will, unfortunately, result in inflation. They will have to raise rates to kill consumer demand to combat the increased inflation.

How does all this relate to my digital dog coins?

The risk-interest rate relationship is simple: riskier investments require a higher interest rate. And if you keep this in mind when looking at market interest rates, you can understand that a higher determined interest rate reflects that the market has assessed the investment as a higher risk investment.

Knowing how to connect these factors to government policy, it’s a significant factor affecting interest rates. The idea that central banks establish an overall “base level” for interest rates is one framework that works quite well. It is a relatively accurate representation of reality for understanding the reciprocal impacts of all those factors.

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