Week 18: Interest Rates — What the Fed Does, What the Market Does, and How Rates Flow Into Asset Prices

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1. Why This Is Important

There is one number that prices every other number in finance, and it is the discount rate. The discount rate is built out of two pieces: the risk-free Treasury yield, and a credit/equity spread on top. Move the Treasury yield, and *every dollar of every future cash flow on the planet* — your mortgage, your stocks, your private equity fund's NAV, your country's pension liability, the lease on the warehouse next door — silently reprices. There is no asset that sits outside this gravitational field.

The Federal Reserve does not set this number directly. The Fed sets one rate (the overnight federal-funds rate) on one day every six or seven weeks, and the market does the rest. Mortgage rates, the 10-year Treasury, BAA corporate yields, junk-bond spreads, the dollar, and equity multiples all adjust without permission. The Fed plants a flag at the short end; the market builds the curve.

You need to internalise four things from this lesson.

Rates are the universal denominator. A stock at $100 with $5 of

earnings growing at 3% is worth one number at a 4% discount rate and a very different number at an 8% discount rate. Same business, same earnings, different price. The interactive at the end of this lesson lets you slide the discount rate across a typical long-duration cash flow and watch present value collapse. Do that exercise once — really do it, with the slider — and you will never again ask "why did the market drop on the Fed announcement?"

The Fed funds rate is a lever, not a result. What you actually

pay on your mortgage, what an investment-grade firm pays on its bonds, and what the Treasury pays at the 10-year auction are market rates. They are influenced by Fed policy but are not set by it. The cascade chart in §2.1 shows the four layers — funds, 10-year, 30-year mortgage, BAA — and how the spread between them widens in stress and during regime change.

Real rates, not nominal rates, drive valuations. A 5% nominal

yield in a 5% inflation world is the same real return as 0% in a 0% inflation world. The market separates the two through the TIPS breakeven (§2.3). When 2022 happened, nominal yields tripled but real yields went from -1% to +2%. The +3% real-rate move is what crushed long-duration tech, not the nominal headline.

We have lived through exactly two regime breaks in 45 years.

The first was Volcker in 1981, ending double-digit inflation by ratcheting the funds rate to 20% and triggering the four-decade bond bull market. The second is 2022 onward, the end of the zero-bound era. The investors holding 60/40 portfolios in 2026 have spent their whole working career on one side of one regime. They need to know what the other side feels like.

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2. What You Need to Know

2.1 The Rate Cascade — Fed Funds, 10-Year, Mortgage, BAA

The interest-rate universe is not one number. It is a layered hierarchy that the cascade chart makes visible.

Read the chart from the bottom up.

• Fed funds (FEDFUNDS, green) is what banks charge each other

overnight, targeted by the Federal Open Market Committee. It is the only line on this chart the Fed sets directly. From 2009 to 2015 and again 2020 to 2022, this line is pinned at the zero bound. The hiking cycle from March 2022 to mid-2024 walks it from ~0% to ~5.4%.

• 10-year Treasury (DGS10, blue) is the auctioned market yield on

the 10-year US note. It is the most-watched price on earth. Mortgages, long-dated corporates, and stock-market discount rates are all benchmarked against it. Note how it tracks the funds rate over long windows but not short ones — the 10-year is a 10-year forecast of the path of short rates plus a term premium, not a copy of today's funds rate.

• 30-year mortgage (MORTGAGE30US, orange) sits on top of the 10-year

with a spread that compresses in calm markets (~150 bps) and widens in stress (>250 bps in 2008-09 and again in 2022-23). The spread reflects prepayment risk, MBS-investor demand, and bank capacity.

• BAA corporate (BAA, red) is the lowest-rung investment-grade

corporate yield. Its spread over the 10-year Treasury is the market's read on default risk. In 2008-09 the spread blew out from ~170 bps to ~600 bps. In April 2026 it is back near ~190 bps.

What you should take away: the Fed sets one rate, and four other rates move because of it but not in lock-step with it. Understanding which spread is widening, and why, is most of what serious macro analysis actually does.

2.2 The Discount Rate Is the Universal Denominator

Every valuation you will ever see — DDM, DCF, P/E, NAV, IRR — is arithmetic on top of one assumption: the discount rate $r$. We met the simplest form back in Week 5. The Gordon growth model says a perpetuity that pays $D$ next period, growing at $g$ forever, is worth

$$ P = \frac{D}{r - g} $$

Three lines of algebra contain most of what equity valuation is. Notice what happens at the limits.

• $r = 4\%, g = 0\%$ -> $P/D = 25$. A typical bond-like stock.
• $r = 6\%, g = 2\%$ -> $P/D = 25$. Same multiple, totally different

story. Higher growth offsets higher discount.

• $r = 4\%, g = 3\%$ -> $P/D = 100$. The "long-duration growth" multiple

the world saw in 2020-21.

• $r = 8\%, g = 3\%$ -> $P/D = 20$. Same business, +400 bps of discount,

multiple compressed by 80%.

The 2022 collapse in long-duration tech was exactly this last move. Nominal 10-year Treasury yields rose ~250 bps and equity risk premia widened ~150 bps. A 4-percentage-point lift in the discount rate cuts the present value of a long-dated cash-flow stream by roughly half. It did. The interactive at the end of this lesson computes $P/(r-g)$ live so you can stop arguing with the chart and start sliding the slider.

The same denominator drives bond duration (Week 5), real-estate cap rates, private-equity NAV marks, and pension liabilities. Everything financial is a present-value calculation in disguise. The discount rate is the asset-pricing kernel; everything else is decoration.

2.3 Real Rates and TIPS Breakevens

Nominal yield = real yield + expected inflation. The decomposition matters because borrowers and lenders both care about purchasing power, not headline numbers. The Treasury issues two parallel debt instruments: nominal Treasuries (DGS10) and inflation-protected Treasuries (TIPS). The yield difference between them is the 10-year breakeven inflation rate, FRED series T10YIE.

Three points jump out.

The 2008 deflation scare. In November 2008 the breakeven went

negative — the market briefly priced in falling prices for a decade. That single print is why the Fed went to QE in early 2009; negative breakevens were the deflation alarm bell.

The 2022 inflation peak (~2.9%). Even at the peak of 9% headline

CPI, the 10-year breakeven never broke 3%. The bond market believed throughout that the Fed would eventually crush inflation back to target. That belief was right and it kept long-rate panic from becoming a self-fulfilling prophecy.

The April 2026 reading sits in the band the Fed targets, which

is part of why the funds rate is being eased back from peak.

For an equity investor, real rates matter more than nominal because real cash flows (earnings, dividends, rents) inflate with prices. When real rates rise — as they did sharply in 2022 — long-duration equity collapses more than the nominal-rate move alone would predict.

2.4 The 1981 Volcker Peak and the 2020 Zero Bound — Two Regime Breaks

If you compress 60 years of US monetary history into two events, they are these.

In October 1979 through July 1981, Paul Volcker walked into the Fed determined to break double-digit inflation. He did it by letting the funds rate go where it had to: it peaked above 19% in mid-1981. The 10-year Treasury yield peaked at 15.8%. The economy went into a brutal double-dip recession. Inflation broke. And the bond market began a forty-year bull run that did not end until July 2020, when the 10-year yield hit 0.55%. Anyone who bought the long bond in 1981 and held through 2020 made an annualised total return that beat the S&P 500.

In March 2020 through 2022, the Fed cut the funds rate to zero, expanded the balance sheet by $4.6 trillion, and held real rates deeply negative. Asset prices went vertical. Long-duration equity, SPACs, crypto, residential real estate — everything sensitive to the discount rate behaved like the discount rate had been set to zero, because in real terms it had.

These two events bracket the *passive 40-year regime*. The "passive index investing always wins" claim that animates Bogle, Buffett, and the entire ETF industry is built on top of the 1981-2020 bond bull market and the disinflation it carried with it. The strategy works. But the strategy also sat on top of a once-in-history regime backdrop, and the central lesson is that regime backdrops change.

The vol-tail-wags-dog point connects directly: Volcker had to break the bond market to break inflation. In 2022, the Fed had to risk breaking equities to break post-COVID inflation. When the Fed pulls the rate lever hard, the vol tail wags the policy dog. SVB in March 2023 was exactly this — a regional bank duration-mismatched into the hiking cycle, then run on by a Twitter-coordinated depositor base in 36 hours. The Fed's BTFP backstop arrived the next weekend.

2.5 The 2022-2024 Hiking Cycle in Detail

The numbers are worth memorising as a calibration set.

• March 2022: funds rate moves from 0-0.25% to 0.25-0.50%. First

hike in three years.

• November 2022: funds rate at 3.75-4.00% after four consecutive

75-bps moves. Fastest tightening pace since 1981.

• July 2023: peak funds rate of 5.25-5.50%.
• March 2023: SVB, Signature, First Republic. Three banks fail in

a week. The Fed launches the Bank Term Funding Program backstop and keeps hiking.

• 2024: first cut in September (50 bps), then 25-bps cuts through

year-end. Funds rate ends 2024 at 4.25-4.50%.

• April 2026: funds rate has settled; the breakeven is back near

the 2% Fed target (see §2.3). The yield curve, inverted from mid-2022 to early 2025, is back to a normal positive slope.

Three things this cycle taught.

The transmission lag from policy to economy is about 12-18 months.

Hikes that began in March 2022 hit residential housing and small business credit hardest in late 2023 and 2024.

Most of the asset-price damage happens in anticipation of the

cycle, not during it. The S&P bottomed in October 2022, eight months before the peak funds rate. Markets price the discount rate forward.

Duration matters more than ever. The 30-year Treasury lost ~46% of

its price from August 2020 to October 2023. That is bigger than most equity bear markets. Bonds are not "safe."

2.6 Growth Stocks vs Value Stocks Under Rate Changes

Equity duration is real, even though we never quote it. A stock whose earnings grow at 3% with most of its cash flow inside the next five years has a low duration; the discount rate doesn't move it much. A stock whose earnings grow at 25% with the bulk of its cash flow expected ten or twenty years out has a very high duration — it is essentially a long-dated zero-coupon bond.

Mechanically, **growth stocks are long duration. Value stocks are short duration.** When rates rise:

• Growth multiples compress hard. The Nasdaq-100 fell 33% in 2022

while the S&P 500 fell 18% and the Russell 2000 Value fell only 14%. Same earnings season, different sensitivity to $r$.

• Value stocks (banks, utilities, industrials) have shorter cash-flow

duration and often benefit from steeper yield curves directly.

• Bonds, of course, lose price proportionally to duration: 10-year

-18%, 30-year -33% in 2022 alone.

This is why "growth vs value" rotates with the rate cycle, not with investor sentiment. The interactive at the end of this lesson includes a side panel showing exactly how a +100 bps rate move hits four representative cash-flow streams: a 10-year bond, a 30-year bond, a high-growth equity (4% growth, 10-year duration), and a value equity (1% growth, 5-year duration).

The barbell intuition survives this rotation: a long position in short-duration value plus a small allocation to convex long-duration growth gives you both regime payoffs without betting on which regime wins. Pure long-duration tech would have been a career-ender in 2022; pure value would have missed every great investment of the prior decade. The barbell wins because the regime is unknowable and rate moves are large.

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3. Common Misconceptions

"The Fed sets mortgage rates." No. The Fed sets the overnight

funds rate. Mortgages are priced off the 10-year Treasury plus an MBS spread. Both pieces are market-determined.

"Higher rates always mean lower stock prices." Not always. In

the early phase of a rate-hiking cycle, when hikes signal a healthy economy, equities can rise alongside rates. The 2004-06 cycle is the classic example. What matters is whether real rates rise faster than expected growth.

"Inflation is good for stocks because companies raise prices."

Only at moderate levels and only sometimes. Above ~4% inflation, equity multiples compress sharply (1970s, 2022). Stocks are real assets, but they are also long-duration discounted cash flows, and the discount-rate effect dominates above ~3% inflation.

"TIPS protect against inflation." Yes, and they are also long

bonds whose real yield can rise. In 2022 TIPS lost ~12% of principal value because the real-yield component rose, even though they did exactly what they were supposed to on the inflation leg.

"You can't lose money in Treasuries if you hold to maturity."

True for nominal terms, false for real terms. A 30-year bond bought at 1% yield in 2020 will repay every nominal dollar but is locked into a real return of roughly -1% per year for thirty years against 2026 inflation expectations.

"Cash is safe." Cash is safe nominally and dangerous in real

terms during inflation. From 2020 to 2024 a dollar in a 0%-yielding bank account lost ~17% of purchasing power. Cash is a position, not a default. The four-tranche framework explicitly carves out liquidity and T-bills, separately.

"Quantitative easing causes inflation." Eight years of QE from

2009-2017 produced no consumer inflation. The 2020-21 round produced the biggest inflation in 40 years. The difference was fiscal: 2020-21 QE was paired with $5+ trillion of fiscal transfers that put cash directly in consumer hands. QE alone moves bank reserves, not prices.

"The yield curve inversion always means recession." It has

preceded every recession since 1955 with one ambiguous exception — that is a high hit rate, not a guarantee. The 2022-25 inversion is the longest on record and produced a soft landing rather than a classic NBER recession.

"Foreign rates don't matter to US stocks." Wrong. The US dollar

is the world's reserve currency; rate differentials drive the dollar, the dollar drives multinational earnings (~40% of S&P 500 revenue is non-US), and the dollar drives commodity prices. The Bank of Japan's 2024 policy shift was a meaningful S&P 500 input.

"Real rates above 2% are 'normal'." Real rates averaged 2-3%

from 1900 to 1980. They averaged around 0% from 2008 to 2022. There is no single "normal" — the regime defines the level. The regime-change point applies again here.

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4. Q&A Section

Q: If I had to watch only one rate, which one? A: The 10-year Treasury yield. It is the single best summary of every piece of information in the rate market — Fed policy expectations, term premium, real growth expectations, and inflation expectations. It is quoted continuously, has no credit spread, and is the discount rate everyone references.

**Q: What's the difference between the federal funds rate and the "discount rate"?** A: Confusing terminology. The federal funds rate is the overnight interbank lending rate the Fed targets. The Fed's discount rate is the (slightly higher) rate the Fed charges banks that borrow directly from the discount window. In practice the discount window is a backstop; the funds rate is the headline tool. When this lesson says "discount rate" without qualifier, it means the financial-economics discount rate $r$ used in DCF, not the Fed window rate.

Q: How do I know which way real rates are moving? A: Subtract the 10-year breakeven (FRED T10YIE) from the nominal 10-year (FRED DGS10). FRED also publishes DFII10 (the 10-year TIPS yield) directly. Real rate = nominal yield - breakeven. A rising real rate is the most reliable bear signal for long-duration assets.

Q: Should I lock in fixed-rate or floating-rate debt now? A: This is a personal-finance call, not investment advice, but the framework is: if you expect real rates to rise from here, fix; if you expect them to fall, float. With the 10-year at ~4% and breakevens near 2% in April 2026, real rates are around 2% — roughly the long-run average. Neither aggressive lock-in nor aggressive floating looks asymmetric here.

**Q: What is "term premium" and why is everyone always talking about it?** A: The term premium is the extra yield investors demand to hold a long bond instead of rolling short bonds. Mathematically, it is the piece of the 10-year yield that isn't explained by expected future short rates. From 2014 to 2021 it was roughly zero or negative — bond investors paid a premium for safety. In 2024-25 it has crept back to ~50 bps. A higher term premium means longer-duration assets get discounted more.

Q: Does the Fed actually control inflation? A: It controls the demand side of inflation through interest rates and bank reserves. It does not control supply shocks (oil, chips, shipping). The 2021-22 inflation was 60% supply-driven and 40% demand-driven; the Fed could only attack the demand half. Volcker won in 1981 because demand was the dominant driver. 1973-74 inflation was mostly oil-shock supply, and Burns's rate hikes did less.

Q: Why does the bond market sometimes rally on bad economic news? A: Because bad news shifts the path of expected future short rates lower, raising bond prices. Bonds love recessions. Equities mostly hate them. This is the asymmetric correlation that makes 60/40 work. Week 4 covered this; it is the central piece of why a portfolio diversifier exists at all.

Q: How fast does a Fed hike show up in mortgage rates? A: The 30-year mortgage moves on the expectation of Fed action, not the action itself. A "surprise" 25 bps hike moves mortgages maybe 10-20 bps that week. A change in the expected path — for example, a hawkish dot plot — can move mortgages 50-100 bps in a single afternoon. By the time the Fed acts, the cake is mostly baked.

Q: Are TIPS a free lunch in inflationary periods? A: No. TIPS protect the principal against CPI but their real yield floats with the market. In 2022 the real yield rose 250 bps and TIPS prices fell. They protect against unexpected inflation, not against real-rate normalisation. They are insurance, not magic.

**Q: How should I think about the discount rate for my own portfolio decisions?** A: Pick a personal hurdle rate — the return below which a project isn't worth your time. For most US investors with full-equity-risk exposure, this is the 10-year Treasury yield plus an equity risk premium of 4-5%. So in April 2026, with the 10-year at ~4%, your hurdle is ~8-9%. Anything you allocate to should clear that, or you should not be doing it. Alpha is rare: if you can't articulate a reason your idea clears the hurdle, it doesn't.

Q: Is the 1981-2020 bond bull market really over? A: Probably yes, but "probably" is not "definitely." A second wave of disinflation (driven by AI productivity, demographics, globalisation 2.0) could push the 10-year back below 2%. But the baseline case for the rest of this decade is range-bound 3-5% nominal yields, which is the historical norm. Building a portfolio that needs yields to fall to 1% to work — which most aggressive long-duration tech plays implicitly do — is a regime-dependent bet, and the regime has changed.

Q: Where does this lesson connect to the rest of the course? A: It is the macro engine sitting under Week 5 (bonds), Week 4 (60/40), Week 10 (cycles), Week 11 (behavioural pitfalls during rate shocks), Week 13 (long/short and how it plays in different rate regimes). Every asset has a duration. The discount rate moves all of them. This week is the link.