The Fed cut its benchmark rate last week, and the stock market spiked up in response. Whether that’s a long-term response or just a sucker’s sandbag is yet to be seen. The effect on interest rates in the private economy in which most of us operate is…inconsistent. And it will continue to be for a long time, regardless of any subsequent Fed moves.

Yields on longer-term US Treasurys have ticked higher since the Fed approved a 0.5 percentage point rate-cut last week. The yield on the benchmark 10-year US Treasury note, which helps set interest rates on everything from mortgages to corporate bonds, settled Friday at around 3.73%, up from 3.64% the day before the Fed’s move.
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[R]ates on a lot more debt are driven primarily by swings in Treasury yields. Those are set by where investors think the Fed’s short-term rates will go in the future, rather than where they are now.

“Investors” are speculating with that, and banks IMNSHO contribute to the speculation by setting their rates on short-term costs and incomes rather than taking the longer view (banks aren’t the only ones, and financials aren’t the only industry, where this short-term, or perhaps shortsighted, prevails) of setting their longer-term rates based on the longer-term incomes of the actual coupons those longer-term instruments pay.

The speculation is made possible by the difference between yield and coupon. A 10-year Treasury Note (for instance, the following definitions apply to all debt instruments that are bought and sold) has a market price, a (market) yield, and a coupon. The Note, once sold, has a coupon, which is the amount of interest the Note issuer (here, the Fed) commits to pay the Note holder (who won’t necessarily be the original buyer) each period for the entirety of those 10 years (in our example). That interest rate, that coupon rate will be paid at the appointed time regardless of the market price of that Note at the time the payment comes due.

The Note, once sold, also has a yield that is separate from the coupon, and that yield is created by the Note’s market price, and that price is driven by short-term trader investors’ aggregated speculation of where interest rates will be tomorrow and by long-term investors’ aggregated speculation of where interest rates will be by the end of those 10 years. In either case, if the aggregated speculation is that interest rates will be higher, then the next-issued Note will have a commensurately higher coupon—guaranteed interest payout rate. To make current Notes, issued with those smaller coupons, marketable, those Notes’ market prices must fall, raising their coupon rates relative to their market prices to match that next-issued coupon. The opposite happens if the next-issued Note is expected—from those aggregated speculations—to have a smaller coupon.

That price variation, and the associated yield variation, is good for debt instrument traders and speculators, but it does little for interest rate stability, which is important for those who depend on fixed income instruments, like Notes (and Fed bonds, which have even longer lifetimes), for their income. Those folks include more than just the retired or the stereotypical widows and orphans, and they comprise no small fraction of us Americans.

Scrambling for pennies by trading on yield—by trading on the instrument prices, which move in the opposite direction of yield (and which movement is the core of the speculation and the creator of the associated yields)—granted those pennies accumulate, lend to volatility in a milieu that would benefit greatly from more stability.

Such coupon-based stability might facilitate more than yield-based relative volatility the ability for banks to avoid mis-matching short-term risk with long-term risk mistakes of the sort a bank in California and another in New York made not so long ago that cost them their existence and severely damaged their depositors.