Whether it’s the rate on your mortgage or the “yield” you’re earning from a DeFi protocol, interest rates are everywhere around us.

What if we could look at these rates to give us clues about where the market is headed?

There’s a reason the yield curve (read: interest rate curve) is often called the “crystal ball”, a leading indicator of both bull and bear markets.

But first we need to understand what interest rates actually are.

Imagine you’re a lender. What rate would you demand to lend out your money? And if you were a borrower, at what rate might you consider taking a loan?

For a moment let’s pretend there is no default risk, the risk that a lender doesn’t get paid back.

These still turn out to be a pretty difficult questions, but I liked how Jonathan Bier broke it down in his book Reckless: The Story of Cryptocurrency Interest Rates.

He points to four components, paraphrased below according to my understanding, that may factor into interest rates:

In a high growth economy, lenders have a greater opportunity cost. They forego investing in appreciating stocks, and thus demand higher rates to lend out money.

Interest rates are often called the “price of time”. This is because every lender foregoes consumption now in order to be able to consume more later. Likewise, borrowers are making the choice to consume more now at the expense of having less later.

Time preference is not constant in society. For example, in times of war, time preference increases. People want to consume now because they may not be able to later. This results in higher interest rates as the demand from borrowers increases while lenders are less inclined to lend.

Like everything, price is a function of supply and demand. If the supply of credit dries up, we can expect interest rates to increase. This is why interest rates are also referred to as the “price of money”.

For example, in a baby boom like what happened in the US after WWII, there might be a sudden increase in demand for mortgage loans as parents upgrade their houses, driving up interest rates.

Or in DeFi, interest rates skyrocketed in late 2020 on Aave. Was this a function of the difficulty for the supply of credit to keep up with demand to borrow, i.e. due to friction bridging new money on-chain?

And last but not least (though my least favorite), we acknowledge that interest rates do not currently operate in a free market. Central banks and regulators manipulate lending, so a big determinant of interest rates is the decisions these institutions make.

While interest rates certainly tell us things about supply/demand, opportunity cost and time preference today, it turns out they also tell us a lot about the future!

When you make a chart of interest rates for varying loan maturities (i.e of US treasuries), you get what’s called the yield curve.

For example, if current interest rates for US Treasuries were…

• A 1 month loan to the US government yields 2%

• A 6 month loan yields 3%

• A 12 month loan yields 3.5%

…we’d get a curve that looks a bit like this:

Though it may readily apparent, from the shape of this red line we can actually divine the market’s expectations of future rates.

In the next newsletter we’ll explore how this is derived, and we’ll start connecting the dots to what the current yield curve says about where the economy (and crypto) is headed.

Whether it’s the rate on your mortgage or the “yield” you’re earning from a DeFi protocol, interest rates are everywhere around us.

What if we could look at these rates to give us clues about where the market is headed?

There’s a reason the yield curve (read: interest rate curve) is often called the “crystal ball”, a leading indicator of both bull and bear markets.

But first we need to understand what interest rates actually are.

Imagine you’re a lender. What rate would you demand to lend out your money? And if you were a borrower, at what rate might you consider taking a loan?

For a moment let’s pretend there is no default risk, the risk that a lender doesn’t get paid back.

These still turn out to be a pretty difficult questions, but I liked how Jonathan Bier broke it down in his book Reckless: The Story of Cryptocurrency Interest Rates.

He points to four components, paraphrased below according to my understanding, that may factor into interest rates:

In a high growth economy, lenders have a greater opportunity cost. They forego investing in appreciating stocks, and thus demand higher rates to lend out money.

Interest rates are often called the “price of time”. This is because every lender foregoes consumption now in order to be able to consume more later. Likewise, borrowers are making the choice to consume more now at the expense of having less later.

Time preference is not constant in society. For example, in times of war, time preference increases. People want to consume now because they may not be able to later. This results in higher interest rates as the demand from borrowers increases while lenders are less inclined to lend.

Like everything, price is a function of supply and demand. If the supply of credit dries up, we can expect interest rates to increase. This is why interest rates are also referred to as the “price of money”.

For example, in a baby boom like what happened in the US after WWII, there might be a sudden increase in demand for mortgage loans as parents upgrade their houses, driving up interest rates.

Or in DeFi, interest rates skyrocketed in late 2020 on Aave. Was this a function of the difficulty for the supply of credit to keep up with demand to borrow, i.e. due to friction bridging new money on-chain?

And last but not least (though my least favorite), we acknowledge that interest rates do not currently operate in a free market. Central banks and regulators manipulate lending, so a big determinant of interest rates is the decisions these institutions make.

While interest rates certainly tell us things about supply/demand, opportunity cost and time preference today, it turns out they also tell us a lot about the future!

When you make a chart of interest rates for varying loan maturities (i.e of US treasuries), you get what’s called the yield curve.

For example, if current interest rates for US Treasuries were…

• A 1 month loan to the US government yields 2%

• A 6 month loan yields 3%

• A 12 month loan yields 3.5%

…we’d get a curve that looks a bit like this:

Though it may readily apparent, from the shape of this red line we can actually divine the market’s expectations of future rates.

In the next newsletter we’ll explore how this is derived, and we’ll start connecting the dots to what the current yield curve says about where the economy (and crypto) is headed.