Interest Rates: The Price of Money

How The Fed Funds Rate Works

• Banks lend to each other overnight to meet reserve requirements
• The Fed sets a target rate and uses open market operations to achieve it
• All other rates are built on top of this baseline + a risk spread

Typical Spread Examples

Product	Rate Basis	Typical Spread	Example
Credit Cards	Prime Rate	+10% to +20%	Prime 8% → Card 18%
Mortgages	10Y Treasury	+1.5% to +2.5%	10Y 4% → Mortgage ~6%
Auto Loans	Fed Funds	+3% to +8%	Fed 5% → Auto 9%
Corporate Debt	SOFR	+1% to +4%	SOFR 5% → Loan 7%

Rates and Asset Valuation

Discount rate (r) is used to value future cash flows. When r rises, present value falls.

PV = CF1/(1+r) + CF2/(1+r)^2 + ...

• High rates → Lower present value → Lower stock prices
• Low rates → Higher present value → Higher stock prices

Housing and Rates

• Mortgage payments are highly sensitive to rates
• A 2% rate increase can reduce affordability by ~20-30%

Example:

• $500k house, 20% down, 30-year fixed
• 3% rate → $1,686/month
• 7% rate → $2,661/month
• +$975/month (58% increase) → Prices must adjust or demand falls

Strategy Playbook by Rate Cycle

Cycle	What Fed Says	Macro	Strategy
Hiking	”We will do whatever it takes”	Slow growth, rising unemployment	Defensive (cash, value, short duration)
Pause	”Data dependent”	Bottom forming	Accumulate quality assets
Cutting	”Ensure soft landing”	Recovery ahead	Go risk-on (growth, long duration)
ZIRP	”Support economy”	Cheap money	Max risk-on, leverage OK

Watch These Signals

• Fed Dot Plot (future rate expectations)
• CPI trend (falling → cuts ahead)
• Unemployment (rising → cuts ahead)
• 2s/10s yield curve (inversion → recession)

Next Steps

• Understand QE (money creation) →
• See Fed policy toolkit →
• Protect from inflation →
• Track treasury yields