No doubt about it - financial market participants are excited when interest rates fall. Both bond and stock market professionals prefer low and falling interest rates to rising rates. Although bond market players typically speculate about the direction of interest rates (and can earn a profit even in a rising rate environment), they still prefer lower rates because they often hold bonds in inventory. Bonds will appreciate in value when the level of interest rates fall, but will lose value when interest rates rise.

Stock market players prefer low interest rates for other reasons. A low interest rate environment implies greater economic activity and more corporate profits. Lower interest rates lead to higher values for future earnings, and future earnings determine the current level of stock prices.

Many consumers also prefer low rates because borrowing costs are reduced. Consumers regularly borrow money to purchase large-ticket items such as cars and furniture. And few would be able to purchase their homes without loans - which is the largest debt burden usually undertaken by consumers. They also borrow for vacations, boats and education. Through the use of revolving credit cards, consumers even borrow for nondurable goods purchases.

In their role as savers, however, consumers would rather see high interest rates to earn better interest income on their savings. Investors with a low tolerance for risk usually weight their portfolio with a greater share of bonds because they consider bond prices to be less volatile than stock prices. When investors look for interest income, higher yields are viewed favorably.

The pace of economic activity along with the rate of inflation help to determine the overall level of interest rates. Yields on corporate bonds vary by credit risk. Less risky bonds offered by companies with high credit ratings will have lower yields than company bonds that suffer from greater default risk. Junk bonds find their demand because they carry higher yields to entice investors to take on the greater risk coming from low credit ratings (Investors shouldn't forget that the risk of default on these "junk" bonds is very real!) Retirees, who used to be called coupon clippers since they typically held a good portion of coupon-bearing bonds in their portfolios, also favor high interest rate levels.

Some investors hold their securities to maturity; they may not care how interest rates are behaving over the maturity period. Other investors buy bonds that they will sell before maturity; they are looking for appreciation rather than yield. These investors would prefer to see bond yields fall just after their bond purchase. The more interest rates decline, the greater the appreciation in their bonds.

Interest Rate Spreads for Consumer Loans
When interest rates are high and rising, consumers often blame bankers for being greedy. After all, only bankers could benefit from high rates, right? Not usually. Consumers must remember that bankers need to add a spread to market rates when making loans. It is harder to maintain fat spreads when interest rates are high.

Note that the spread between the federal funds rate and the prime rate widened significantly in 1992 and has remained a solid 3 percentage points ever since. The Federal Reserve maintained a low federal funds rate target, for a longer period than expected by economists, in order to allow banks to shore up capital even as the economy was coming out of recession between 1992 and 1994.

Before the 1980s the prime rate, also called the "corporate base rate", was known as the rate which banks charged their best customers. Since the early 1980s, the "best customers" learned to negotiate loan rates that were tied more closely to market securities such as Treasury bills, commercial paper, certificate of deposits, and Eurodollars. Consumer loans are now also tied to the prime rate. In fact, many banks advertise home equity loan rates that are equal to the prime.

Federal Funds Rate Guides Consumer Loan Rates
In the old days (just a few years ago) consumers didn't pay too much attention to changes in the Federal Reserve's federal funds rate target. After all, the federal funds rate is the rate which banks charge each other for the use of overnight funds. It isn't a consumer rate at all. Yet, the nonfinancial press regularly reports on Federal Reserve actions in this competitive and sophisticated environment.

Looking at the charts below, one wouldn't think that consumer lending rates are tied to the federal funds rate at all. The first chart compares personal loan rates to the fed funds rate. Again, you'll see a slight downward trend in personal loan rates, but they don't seem to move in tandem with movements in the fed funds rate. This looks like a market that is affected by economic factors within its own industry. For instance, personal loan rates depend on individual credit ratings. Often personal loans are undertaken by individuals with higher (default) risks or poor collateral. Spreads remain wide even in low interest rate environments.

But the auto loan market shows a different picture. Interest rates are more closely aligned to movements in the federal funds rate. The spread between auto loan rates and the fed funds rate has been pretty stable over the past twenty years. It is worth noting that auto finance companies compete with banks for these loans. As a result, banks garner a smaller spread on these loans than on personal loans.

If we look at auto loan rates offered by finance companies rather than banks, the picture changes dramatically. Clearly, automakers have the ability to spur car sales by either lowering car prices or financing rates. They have used both factors historically to jump start motor vehicle sales. The column reflects the spread between the federal funds rate and the financing rate for new cars. Since this spread narrowed sharply in the second half of 1996 and has not returned to the higher spreads common in the 1980s and first half of the 1990s. The spread between the federal funds rate and the financing rate for used cars is much wider, reflecting the higher risk for lenders in this market.

Mortgage Rates
Mortgage rates on fixed rate 30-year loans generally move in tandem with the yield on the 10-year Treasury note. The chart below depicts the spread between the mortgage commitment rate and the 10-year Treasury note. The spread varied in the early 1980s when interest rates were at double-digits. Since 1987, the spread relationship has exhibited more stability. However, it is interesting to note that the spread jumped in 1998 and has since fluctuated between 1.5 and 2 percentage points.

Yields on Treasury securities fell rapidly in the summer of 1998 when global financial turmoil pushed many investors from the U.S. and abroad out of the stock market and into the safe-haven of U.S Treasuries. From 1999 to the first half of 2001, yields on Treasury securities have fallen because borrowing needs have diminished and the Treasury reduced the supply of new securities coming to market. Fed easing to quell recessionary pressures in 2001 helped contain yields too. Treasury prices surged (and yields plunged) in the wake of the September 11 tragedy that had investors fleeing to safe-haven investments.

Interest Earnings for Investors
Consumer loan rates haven't decreased as much as the federal funds rate. Nevertheless, rates that consumers earn on savings accounts or bonds have decreased somewhat more rapidly. The charts below depict average yields on Treasury securities, corporate bonds and municipal bonds. Rates that banks offer on certificates of deposit would have decreased by similar amounts.

Given the 475 basis point plunge in the federal funds target, yields on long-term Treasury securities have barely budged in 2001. The chart below shows how spreads have widened in the past year between the risk-free 30-year Treasury bond and long-term corporate bonds. The wider gap reflects deteriorating credit conditions.

Finally, the last chart shows how the spread between the 30-year Treasury bond and average yields on long-term municipal bonds has narrowed. Remember that the interest earned on municipal bonds is tax-free. That means that the yield on municipals should be lower than that on taxable securities. Municipal bonds are not as liquid as Treasury securities and do suffer from default risk. The spread varies, but it is not usually zero. The lower yield on the 30-year Treasury bond stems from a reduction in supply of this security.

Bottom Line
When interest rates are falling, rates on interest earnings will tend to decline more rapidly than loan rates. That makes it a good idea to pay off loans or incur less new debt since interest earned will be less than interest paid. In a rising interest rate environment, borrowing costs will certainly increase but investors have an opportunity to buy fixed income instruments with higher yields that will generate interest income for a longer time period.

In trying to increase interest income, investors may buy junk bonds with low credit ratings to earn a higher yield. But if interest rates are declining because the economy is softening, it could increase default risk. Remember that higher yields do come with higher risk.

So which do you prefer, low or high interest rates?

Evelina M. Tainer, Chief Economist, Econoday