Economics 101: What determines long-term interest rates?

By ERIC VAN ENK on September 9, 2023.

Short-term interest rates are determined by central bank policy. For example, the Bank of Canada sets its overnight rate (rate commercial banks are charged to borrow from the Bank of Canada) at the level it believes will maintain inflation within its stated band of 1-3%. If inflation is higher than central banks desire, they increase the overnight rate to slow the economy. If inflation is lower than they want, they decrease the overnight rate to stimulate the economy.

What isn’t as well understood is how longer-term interest rates are set. For example, what determines the rate you are charged for a five-year mortgage? Longer-term interest rates are determined by the bond market with the U.S. bond market being the world’s largest and most influential.

The simplest way to understand long-term interest rates is they are determined by the rate which balances supply and demand for government bonds. For example, the U.S. 30-year interest rate fluctuates daily based on the price of the U.S. 30-year bond. As the price of the U.S. 30-year bond moves higher, 30-year interest rates decrease and vice versa.

If demand for 30-year bonds is higher than supply, the price of the bond must move higher to balance supply and demand. Conversely, if supply for the 30-year bond is higher than demand, the price of the bond moves lower. As shown in this week’s chart, foreign buyers of U.S. bonds are buying less than they have at any point over the past decade.

The largest foreign buyers of U.S. bonds are Japan and China which have both decreased their purchases in recent years.

You may have noticed a recent increase in longer-term interest rates both in Canada and the U.S.. The reason for this move can be attributed to an increase in supply and a decrease in demand for U.S. bonds. The largest buyer of U.S. bonds has been the Federal Reserve through Quantitative Easing. As I’ve written about previously, the Federal Reserve has reversed course from QE and is now selling bonds through what is known as Quantitative Tightening. This means the largest buyer of U.S. bonds has become a seller. In addition to losing the largest buyer for U.S. bonds, the second and third largest buyers (Japan and China) are buying less because they are buying bonds denominated in their own currency to help support their economies.

Decreased demand for U.S. bonds is occurring while the supply is increasing. The reason for an increase in supply is record deficits and the recent increase in the debt ceiling. Once the debt ceiling in the U.S. was increased, the U.S. Treasury began increasing the amount of bonds they sell to pay for record deficits. In simple terms, the U.S. is borrowing more money than ever. Decreased demand and increased supply is driving bond prices lower and interest rates higher. Long-term interest rates could move even higher if the current trends of increasing supply and decreasing demand for U.S. bonds persists.

Eric Van Enk is a wealth adviser & associate portfolio manager with National Bank Financial in Medicine Hat. He is a graduate of the University of Calgary, as well as a CFA charter holder with 20 years of financial markets experience in New York, Toronto and Calgary. He can be reached at eric.vanenk@nbc.ca

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