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To trade stocks that are sensitive to interest rates you will need to understand the Yield Curve. The Yield Curve is how banks make their
money but can have a strong effect on any financial services company.
By borrowing money at the short term interest rate and lending it at the long term interest rate, banks make money on the difference
between the two interest rates. If a bank can borrow at 1% interest and make loans at 6% interest, then they can pocket 5% for themselves.
This principle makes banking an extremely profitable business.
Banks usually borrow money from their depositors or from the Money Market. These are very short term loans since the depositor can demand
the money back at any time, therefore they pay out much less interest. The money is then lent out for a much longer period of time (called the
"maturity"). Below is an example of some Yield Curves:
The above Yield Curves are perfectly straight for demonstration
purposes but they usually have some sort of curvature to them.
A "steep" Yield Curve means the short term interest rate is much lower than the long term interest rate, which is very profitable
for the banks.
A "flat" Yield Curve will make banking unprofitable. The worst
Yield Curve is an inverted Yield Curve, which turns banks into
money losers. In an inverted Yield Curve the short term interest
rates are higher than the long term interest rates. Flat and
inverted Yield Curves occur when the Federal Reserve is raising
short term rates to slow down the economy because inflation is
too high or may become too high if action is not taken.
When the economy is growing fast, the Federal Reserve will "tighten"(raise) interest rates. This will hurt the performance of the
banks and any similar financial services company that makes its living off of the Yield Curve. This is true no matter how well run the bank is.
If a company makes heavy use of variable interest rate loans, then that can help reduce the impact of rising interest rates.
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