Interest rates and the yield curve – the cost of money over time

The price of money is the only price that affects the price of every other asset. Central bank interest rates, bond yields and the yield curve together form a map of that cost over time. If you do not understand it, you do not understand why your technology ETF falls when “nothing happened at the companies”.

This lesson explains the mechanics without macro poetry: how rates affect valuation, what the curve is, and how to read expectations and risk from it.

The central bank interest rate – not the price of credit, but the anchor of expectations

A central bank (the Fed, the ECB, the NBP) does not set every rate in the economy. It sets the short-term (overnight) rate, and the rest is the market’s expectation of what it will do next.

For a trader, three things matter:

1. The level of the real rate, not the nominal one: Real = Nominal - Expected inflation. With a rate of 5.5% and inflation of 3.5%, the real rate is 2%. It is the real rate that slows down or stimulates the economy.
2. Forward guidance – communication: What the bank says about the future matters more than today’s decision. “We are raising by 0.25%, but we are ending the cycle” is dovish.
3. Discounting: Every stock is a stream of future earnings. A higher rate = stronger discounting of those earnings. The worst hit are companies whose earnings lie far in the future (growth, tech).

Formula – a simplified valuation model:

Company_Value = Sum ( Profit_t / (1 + Discount_Rate)^t )

Where:
Discount_Rate = Risk_Free_Rate + Risk_Premium

If the Risk_Free_Rate (10Y yield) rises from 2% to 4.5%, the denominator grows,
the value falls – even with the same earnings.

For an ETF: the higher the duration, the greater the sensitivity to rates. A long-term bond ETF (TLT) behaves like a growth stock in that respect.

The yield curve – what the shape says

The yield curve is a chart of the yields of government bonds with different maturities: from 1 month to 30 years. Normally a longer maturity = a higher yield (you are paid for time risk). But the curve changes shape, and that is the signal.

The measures the market watches:

• The 10Y-2Y spread: The most frequently quoted. In the USA, inversion (a negative value) preceded every recession since 1970, but with a lag of 6-18 months and with false signals.
• The 10Y-3M spread: The Fed treats it more seriously than 10Y-2Y.
• The 10Y real yield (TIPS): If the real yield rises, stocks have a harder time, because the alternative (a safe real rate) is tempting.

Spread_10Y_2Y = Yield_10_years - Yield_2_years
If Spread_10Y_2Y < 0 -> Inverted curve
Real_Rate_10Y = Nominal_Yield_10Y - Break_Even_Inflation_10Y

Transmission to stocks and ETFs – how to calculate it

Do not guess. Measure the sensitivity.

1. Beta to rates: Check the weekly correlation of your ETF with the 10Y yield over the last 90 days. If the correlation is -0.7, then a 0.20% (20bp) rise in the yield was statistically associated with a fall in the ETF.
2. Equity duration: Growth companies have a high “duration”. A rule of thumb: companies with a low FCF Yield ratio and a high P/E have a duration of > 15 years.
3. Sectors: Most sensitive to rising rates: unprofitable technology, real estate (REITs), small companies dependent on financing. Least sensitive: banks (up to a point), energy, value companies with a dividend.

A practical filter:

Change_in_ETF_Value ≈ -Effective_Duration * Change_in_Yield

TLT ETF (duration ~17) + a 10Y rise of 0.50% -> a fall of ~8.5%
Technology ETF (equity duration ~20) + a 10Y real rise of 0.30% -> ~6% pressure

This is not a forecast, it is a measurement of risk. If you know that CPI is coming and yields could move by 15bp, you know by how much your instrument could theoretically give back.

When the plan says DO NOT TRADE

1. The day of a Fed/ECB/RPP decision, if you have no defined reaction to every variant of the communication. The rate decision itself is often in line with the forecast. It is the press conference that moves the market by 1.5%. If you do not listen to the Q&A, you do not know what the market is reacting to.
2. When the curve suddenly changes shape intraday. A bull steepening on weak jobs data can cut 2% off growth within an hour. Do not go against rate momentum without a stop plan.
3. When real yields are rising and you want to add to the longest-duration assets without a hedge. The plan says: either cut the position, or accept that you have a bet on falling real rates and calculate the maximum loss.
4. When the credit spread (e.g. HYG vs TLT) is widening and you ignore the signal. A widening credit spread = the market is starting to fear for solvency. It is a signal that even if rates fall, stocks may not rise.

Mistakes that cost the most

1. Confusing nominal with real. The nominal yield falls, but inflation falls faster – the real one rises. The trader thinks: “rates are falling, I’m buying tech”. Meanwhile the real cost of money is rising – pressure on valuations.

2. Trading the curve inversion as an immediate recession signal. An inversion is not a “sell everything” button. From inversion to the bottom of the S&P 500, an average of 12 months passes. If you close everything on the day of the inversion, you will often lose the best part of the bull market.

3. Ignoring the central bank’s balance sheet (QT/QE). Rates are the price of money, QT/QE is the quantity of money. The Fed may not touch rates, but by doing QT of 95 billion a month it tightens liquidity conditions. The effect: higher long-end yields despite a pause in rates.

4. No measurement of your own duration exposure. A trader has 5 positions, all with high duration, and is surprised that the portfolio falls when the 10Y goes from 3.8% to 4.6%. The portfolio’s internal correlation = 1 on the rate factor.

Measurable exercise [20 minutes]

Goal: To calculate the sensitivity of your portfolio/watchlist to rates.

Steps:

1. Take 2 ETFs: one equity growth (e.g. QQQ) and one long bond (e.g. TLT) + the WIG20 as the PL benchmark.
2. Download the data: the US 10Y yield (US10Y) over the last 90 days and the ETFs’ closing prices.
3. Calculate the 90-day correlation (the CORREL function in a spreadsheet) and the ETF’s % change on the days when the 10Y moved by >10bp.
4. Fill in the table:

5. Write down: what rise in yields wipes out your daily loss limit?

Pass criterion: You have a calculated correlation and a scenario: “If the 10Y rises by 20bp, my portfolio loses on average X% based on historical data”. That is your interest rate limit.

# Formula for the portfolio's estimated loss
Estimated_Loss = Sum ( Position_Weight_i * Correlation_i_10Y * Beta_i * Change_in_Yield )

Check yourself

1. The Fed raises the rate in line with the forecast, but at the conference says it “will pause and assess the data”. The 10Y yield falls. What do you call it? a) A hawkish hike b) A dovish hike – the communication matters more than the hike itself c) A market error

Correct: b) The market trades the future, not the present. Forward guidance is key.

2. The 10Y-2Y spread is -0.80%. What does that mean? a) A normal curve b) An inverted curve, short rates higher than long ones, the market is pricing in future cuts c) That 10Y bonds are safer than 2Y

Correct: b) It is a historical but lagging recession signal. Not an intraday signal.

3. The 10Y real yield rises from 1.5% to 2.2% in a month, while the nominal one is unchanged. What happened to inflation expectations? a) They rose b) They fell – the market thinks inflation will be lower, so the real rate is a larger part of the nominal one c) They are unrelated

Correct: b) Real = Nominal - Breakeven. If the nominal is constant while the real is up, the breakeven (expected inflation) is down.

Frequently asked questions

Do I have to track every curve – the USA, Germany, Poland? Start with the US 10Y – it is the global anchor. If you trade in Poland, add the Polish 10Y. The difference (spread) between PL10Y and DE10Y/US10Y is the country risk premium.

Why do stocks sometimes rise despite rising yields? Because yields can rise for two reasons: (1) because real growth is rising = good for earnings, (2) because inflation is rising without growth = bad for earnings. The distinction: check whether it is the real rate or the breakeven that is rising. A rise driven by growth – the market often accepts it.

Can I use bond ETFs as a hedge against a fall in growth stocks? Not directly. Long government bonds sometimes rise when stocks fall (flight to safety), but if the fall in stocks is caused by rising rates, both will fall. A hedge has to be measured with conditional correlation, not constant.

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This is not investment advice. The interest rate is a risk parameter – measure the sensitivity, do not guess the direction.

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