How central banks set rates
Interest rates are the price of borrowing money. When a central bank — the Federal Reserve in the US, the ECB in Europe, the Bank of Japan — raises rates, every loan in the economy becomes more expensive. Mortgages, car loans, corporate bonds, leveraged buyouts, government debt. The cost of carrying all of it goes up.
The Fed sets the federal funds rate — the rate at which banks lend to each other overnight. From there, rates ripple up the yield curve, influencing the rate on everything from 3-month T-bills to 30-year mortgages. The Fed doesn't directly control long rates, but it influences them through its signals and through buying or selling in its open market operations.
When the Fed wants to slow the economy (inflation is too high), it raises rates. When it wants to stimulate (unemployment is too high, growth is too slow), it cuts them. This is the core lever of monetary policy.
Rate changes work with a lag. A hike in May might not show up in consumer spending data until September or November. Traders must think ahead of the data, pricing in what the rate trajectory implies for corporate earnings, housing, and consumer behavior 6-12 months out.
How rates affect asset prices
Higher rates hurt equities through two channels. First, they raise the discount rate used to value future earnings — in a DCF model, higher rates mean lower present values. Growth stocks, whose earnings are weighted toward the future, get hit hardest. Second, higher rates make the risk-free rate (Treasuries) more attractive relative to equities, pulling money out of stocks.
Bonds are directly priced by rates. When rates rise, existing bond prices fall (inverse relationship). Duration measures this sensitivity — a 10-year bond is far more sensitive to rate changes than a 2-year bond. This is why long-duration bonds (TLT) behave like growth stocks in rate environments.
Real estate is another rate-sensitive sector. Mortgage rates track long rates, and when mortgages become expensive, housing demand falls. Homebuilder stocks, REITs, and mortgage originator stocks all lead housing turn down when the rate cycle turns up.
Reading the Fed
The Fed communicates through FOMC meeting statements, the dot plot (projections for future rates from each member), press conferences, and speeches. Traders spend significant effort trying to decode these signals — the market prices rate expectations through federal funds futures, which you can read directly.
The key concept: market prices already reflect consensus rate expectations. A "rate hike" that was fully priced in causes no move. An unexpected hike, or hawkish language beyond expectations, causes the move. You're trading surprises relative to what the market expected, not the absolute level of rates.
Watch the 2-year Treasury yield as your real-time rate expectation indicator. It tracks the Fed more closely than any other instrument. When it moves hard in either direction, the market is repricing the rate outlook, and equities usually follow.