Someone asked me why when interest rates rise the fixed rates move upwards first and when interest rates fall fixed rates fall first

When interest rates rise or fall, fixed rates (such as fixed-rate mortgages or fixed-rate bonds) often move before variable rates because of how financial markets, lenders, and investors anticipate and respond to changes in the overall interest rate environment. Here’s an in-depth explanation of why this happens:

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Understanding Fixed vs. Variable Rates

?Fixed Rates: A fixed-rate loan or bond locks in an interest rate for a set period, regardless of how interest rates change afterwards.

?Variable Rates: A variable (or floating) rate loan has an interest rate that adjusts periodically, typically linked to a benchmark (e.g., the prime rate or LIBOR).

Role of Central Banks and Market Anticipation

?? Central banks (like the Federal Reserve, the European Central Bank, or the Bank of England) set benchmark interest rates to control inflation, stabilize currencies, and influence economic growth. These rates are not directly tied to consumer loan rates but serve as a signal to financial markets about the cost of borrowing in the economy.?

Rising Interest Rates: When central banks signal that they will raise interest rates (or actually raise them), lenders and investors anticipate higher borrowing costs in the future. Fixed-rate instruments like mortgages or bonds are priced based on the expectation of future interest rates.??

Impact on Fixed Rates: Fixed-rate loans are typically financed by lenders selling bonds or other financial instruments in the capital markets. If interest rates are expected to rise, new bonds issued by lenders need to offer higher interest rates to attract investors, who would otherwise wait for even higher returns. Therefore, to maintain profitability, lenders adjust their fixed-rate offerings upward quickly.

Why Fixed Rates Rise First: Since fixed rates are locked in for long periods, lenders must price these products based on future rate expectations. When rates are expected to rise, lenders increase fixed rates quickly to avoid locking themselves into lower yields for the duration of the loan or bond.?

Falling Interest Rates: Conversely, when central banks signal or initiate rate cuts, market participants expect borrowing costs to decrease in the future. As a result, lenders anticipate lower interest rates and thus reduce the fixed rates they offer.?

?Impact on Fixed Rates: If rates fall, the returns on new fixed-rate loans or bonds become less attractive, especially if there are higher-yielding alternatives from the past. Lenders quickly lower fixed rates to stay competitive and align with future lower borrowing costs.

Why Fixed Rates Fall First: Lenders try to secure demand for their fixed-rate products by quickly lowering rates to reflect future expectations. If they don’t adjust quickly, they risk offering fixed-rate products that are too expensive relative to the new lower interest rate environment, which could reduce demand.

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Pricing and Yield Curves

?? The yield curve (which plots interest rates for bonds of different maturities) is a critical factor in understanding why fixed rates move first. When the central bank signals a change in the direction of interest rates, the yield curve shifts.?

When Interest Rates Are Expected to Rise: The yield curve steepens, meaning long-term rates rise more than short-term rates. Fixed-rate instruments, which are long-term, adjust upward more significantly to reflect this change.

When Interest Rates Are Expected to Fall: The yield curve flattens or inverts, meaning short-term rates fall faster than long-term rates. Since fixed-rate instruments are often linked to longer-term bonds, they adjust downward faster as well

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Risk Premiums and Inflation

Rising Rates and Risk Premium: When interest rates rise, inflation expectations typically increase. Lenders and investors demand higher interest rates on fixed-rate loans to compensate for the risk of inflation eroding the real value of future cash flows. This increases fixed rates.

Falling Rates and Lower Risk Premium: When rates fall, inflation expectations decrease, reducing the risk premium lenders require on fixed-rate loans, which leads to a drop in fixed rates.

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Lender's Cost of Funding and Competition

Cost of Funding: Lenders fund their loans by borrowing money themselves. When central banks raise interest rates, lenders' own borrowing costs go up. To maintain profit margins, lenders increase the fixed rates they offer to consumers. Conversely, when interest rates fall, lenders’ cost of funding decreases, allowing them to offer lower fixed rates.

Competition: Fixed-rate loans, especially mortgages, are competitive products. Banks and financial institutions move quickly to adjust their rates to align with market conditions and attract borrowers. If a bank keeps its fixed rates too high when central rates are falling, it risks losing business.?

Interest Rate Swaps and Hedging

Hedging Fixed Rates: Lenders often use interest rate swaps to hedge their exposure to changes in interest rates. An interest rate swap allows them to convert floating-rate payments into fixed-rate payments. When the expectation of higher rates grows, the cost of these swaps increases, pushing fixed rates higher faster. The opposite happens when rates are expected to fall, causing fixed rates to decrease first.?

Behavior of Variable Rates

Variable rates adjust more slowly for a few reasons:

Index Linking: Variable rates are typically tied to an index (like the prime rate, LIBOR, or another benchmark), which adjusts at set intervals (monthly, quarterly, or annually). This delay means that variable rates react more slowly to changes in central bank policy compared to fixed rates.

Lender Strategy: Lenders may not immediately adjust variable rates to avoid alienating customers with frequent changes. There’s often a lag before variable rates fully reflect changes in benchmark rates.

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Summary of Why Fixed Rates Move First:

Expectations of Future Rates: Lenders and markets anticipate central bank moves and fixed rates quickly adjust to reflect these expectations.

Yield Curve Dynamics: Long-term rates (which affect fixed-rate loans) are more sensitive to rate expectations, causing fixed rates to move before variable rates.

Risk and Inflation Premiums: As interest rates rise, lenders demand higher premiums on fixed-rate loans to hedge against inflation and risk. When rates fall, these premiums decrease, and fixed rates drop.

Cost of Funding: The cost of funding for lenders rises and falls with interest rates, which influences how they price fixed-rate products.

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The quick adjustment in fixed rates ensures that lenders and investors don’t lock in unprofitable or overly risky long-term contracts, given expected changes in the overall interest rate environment.

Keep in mind just as there are several upward movements in fixed and variable rates, so it is true when they fall.

Some Australian Banks have now adjusted fixed rates down twice, soon we will see the variable rate markets start to fall, how many times the RBA adjusts benchmark rates down is still to be seen until we see the bottoming out of the interest rate market.