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What causes the consumer / business loans interest's rate to go up whenever the yields on U.S Treasury bonds go up?

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Consumer and commercial loan rates are made up of two components: the "risk-free" rate (the yield that you get from government-backed debt) and a "spread" that represents the risk of default, plus some profit margin for the lender. The higher the risk of default, the more the bank charges to loan money, to offset that risk.

So as government yields rise, so too does the "base" rate for these loans, and thus the overall rate goes up as well (assuming the risk of default does not change).

It's similar to how the price of applesauce rises when the price of apples goes up. The cost to process apples has not changed, so the producer just charges more for applesauce rather then reducing their profit margin.

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  • Thanks for the answer. I still don't understand it. If bond yields go from 2% to 3%, which means I'm technically making more money when holding a bond, why would the interest rate that a bank charges me increase too? How one thing relates to the other one? Dec 2, 2020 at 19:30
  • You're comparing different things. If you hold an existing gov bond and yields go up, then you only "make money" if you sell the bond (otherwise the interest you get is fixed). But, suppose yields rose above bank rates. Then you could borrow money and buy bonds at a higher rate than your loan. So bank rates must be higher to avoid this type of arbitrage (it's not the actual cause-and-effect but it illustrated why they're linked)
    – D Stanley
    Dec 2, 2020 at 20:48
  • I see. So basically it's a way to prevent folks making more money from bond yields. If I'm making 5% of a yield in a bond, I will be "penalized" by a higher interest rate if I try to borrow money from a bank, by having an interest rate that is higher than 5%. Dec 3, 2020 at 11:55
  • That's one way to look at it, but fundamentally it''s because banks must borrow money at the fed rate (if they don't have enough in deposits) and so lend it out at that rate plus a spread to account for risk and profit. The fed rate is analogous to the "wholesale" cost of goods for a business.
    – D Stanley
    Dec 3, 2020 at 14:19

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