1. The interest rate and what 'risk-free' means

Macro 1: The price of money

The whole edifice of the markets rests on a single number: what money costs over a period of time. That number is the interest rate. It is not the whim of a central banker in a suit: it is the price of a very specific exchange, and understanding that exchange is the difference between knowing why your portfolio moved and merely staring at the chart.

Money has a price because time has a price

A euro today and a euro a year from now are not the same thing, and they are not for three distinct reasons that are best kept separate:

• Time preference. People would rather consume now than later. To persuade you to give up spending today, somebody has to pay you something.
• Opportunity cost. Whoever lends that euro gives up every other use they could have put it to over that year. Interest is the rent charged on that sacrifice.
• Risk and inflation. There is a chance you will not be paid back, and a near-certainty that a year from now that euro will buy fewer things.

The interest rate quoted in the market is the sum of those three pieces. When somebody says 'rates have gone up', what they are saying is that one of those three pieces has changed: either people want to consume more now, or there are more profitable alternative uses for money, or risk and expected inflation have increased. Almost always it is the third.

What 'risk-free' means, and above all what it does not

In finance, a risk-free asset is one that returns a known amount on a known date with practical certainty: typically the short-dated Treasury bill of a country that issues debt in its own currency, such as the United States or Germany. It earns the name because it carries no default risk and no price risk if you hold it to maturity.

Here is the trap a great many people fall into: 'risk-free' means free of nominal risk, not free of real risk. If a one-year bill pays you 2% and inflation that year turns out to be 8%, you have received exactly what was promised and still lost close to 6% of your purchasing power. In 2022 American savers in Treasury bills lived through precisely that: they were paid their coupon on time and lost purchasing power at a pace not seen since the seventies. The risk-free asset does not protect you from inflation; it only removes the uncertainty about the number of euros or dollars you will receive.

Who sets which rate: there is no single interest rate, there is a ladder

Another common confusion is to speak of 'the interest rate' in the singular. There are many, one for each maturity, and they are not all set by the same actor:

• The short end (from overnight out to two years) is controlled by the central bank fairly directly, by setting the rate at which it remunerates and lends reserves to the banking system. When you read that 'the Fed has raised rates', this is what it refers to.
• The long end (ten, thirty years) is set by the market, not by the central bank. It is the product of what millions of bond buyers and sellers believe short rates will average over all those years, plus something extra for bearing the uncertainty of so long a horizon, known as the term premium.

This distinction has a practical consequence that catches people out: the central bank can raise the policy rate and the ten-year rate can sit still, or even fall. It happens when the market reads that rise as cooling the economy so much that cuts will be needed a few years later. It is neither an anomaly nor a mistake by the market: they are two prices answering different questions.

The risk-free rate is the bar everything else has to clear

This is where macro stops being theory and becomes your portfolio. Any risky asset, whether a share, a flat, a corporate bond or an algorithmic strategy, has to offer more than the risk-free asset, because otherwise nobody rational would buy it: you would be taking on uncertainty in exchange for nothing. That difference is called the risk premium.

And so, when the bar rises, everything else has to reprice downwards even though absolutely nothing has changed in the underlying business. If an asset was going to pay you 5 a year and risk-free money paid nothing, that 5 was attractive. If risk-free money suddenly pays 5, the same asset has to get cheaper until its expected return compensates for the risk once more. The company has not lost a single customer. Its price falls all the same.

2022: the year the bar rose four points

Between March and December 2022 the Federal Reserve took its policy rate from practically zero to around 4.25%-4.50%: some 425 basis points in nine months, the fastest pace of tightening in four decades. Through the preceding years an acronym had done the rounds, TINA (*there is no alternative*): with risk-free money paying zero, there was no alternative to buying shares. In 2022 that alternative reappeared all at once.

The result was not that companies stopped selling. It was that the S&P 500 fell around 18% and long-dated US government debt had its worst year on record, falling at the same time as the stock market. The classic 60/40 portfolio, designed precisely so that one leg cushions the other, lost close to 17%: both legs fell together because the blow came not from the real economy but from the denominator they share.

Take this away with you: the risk-free rate is not background color for the evening news. It is the yardstick against which the price of everything you buy is measured.