What is the Difference Between Long-term and Short-term Interest Rates?

The difference between long-term and short-term interest rates lies in their maturities, sensitivity to interest rate changes, and the factors that influence them. Here are the key differences:

1. Maturities: Short-term interest rates are associated with loans that are payable within a period of less than or equal to one year, while long-term interest rates are associated with loans that have maturities of more than one year.
2. Sensitivity to Interest Rate Changes: Long-term bonds are more sensitive to interest rate changes than short-term bonds due to their greater duration. Duration measures the sensitivity of a bond's price to changes in interest rates. For instance, a bond with a duration of 2.0 years will decrease by 2% for every 1% increase in rates.
3. Factors that Influence: Short-term interest rates, such as the U.S. Bank Prime Rate, tend to move in lockstep with the Federal Reserve's Federal Funds Rate. On the other hand, long-term interest rates are more complex and market-driven, with the Federal Funds Rate being one of the drivers. However, long-term rates do not always move in response to changes by the Fed, especially in the secondary market for mortgage-backed securities (MBS).

In a normal yield curve, short-term interest rates are lower than long-term rates, reflecting higher yields for longer-term investments. However, when short-term interest rates exceed long-term rates, an inverted yield curve occurs, which has been viewed as an indicator of a pending economic recession.

Comparative Table: Long-term vs Short-term Interest Rates

Here is a table comparing the differences between long-term and short-term interest rates:

In general, short-term interest rates are associated with financial assets that have a maturity of less than one year, while long-term interest rates are associated with assets that have a maturity of more than a year. Long-term interest rates tend to be higher than short-term interest rates due to the higher possibility of default. Additionally, short-term interest rates are subject to higher levels of fluctuation in the short term, whereas long-term interest rates are less prone to fluctuations in the short term but could be more volatile in the long run.