# What Is the Interest Rate Spread?

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The interest rate spread can often be used as an indicator of an upcoming recession in the U.S. economy and is a component of the Index of Leading Economic Indicators. The spread is determined by the difference between the short-term federal funds rate and the long-term U.S. Treasury Bond Yield.

## Federal Funds Rate

One figure used to calculate the interest rate spread is the federal funds rate. The rate is the short-term interest rate a financial institution charges another to lend balances at the Federal Reserve overnight. A bank with surplus funds, for example, may lend some of its balance to another bank that needs more funds. The banks negotiate with each other to set the interest rate, and the weighted average of the rates among all institutions becomes the effective federal funds rate. While the Federal Reserve does not set the rate, the Reserve can engage in activity to reach a target rate set by the Federal Open Market Committee.

## Bond Yield

The other figure used to calculate the interest rate spread is the bond yield. Treasury bonds, which are issued for relatively long terms, finance the country's borrowing. A person who buys a bond is lending the money to the U.S., and in return receives interest. This interest is referred to as the "coupon rate." If you own a bond you can sell it before it reaches its maturity date, but at that time, the prevailing coupon rate may have changed. The bond price must be adjusted to reflect the current coupon rate. The bond yield is the financial return the bond owner receives, calculated by dividing the yearly interest rate payment by the current bond price. For example, if you buy a bond for \$5,000 with a coupon rate of 10 percent, the bond pays \$500 a year. If you want to sell the bond in the resale market when the prevailing coupon rate is only 5 percent, the price of the bond would rise to \$10,000 so the bond yield would equal the prevailing interest rate.