What is the goal of this chapter?
To understand how economic factors affect asset prices
What are the main market drivers of assets in the economy?
- Attractiveness of asset values are linked to the interest rates:
-> Asset returns are calculated as returns on
risk free assets + premium for risk factors eg.
unknown expenses, liquidity, inflation etc.
- Interest rates are determined majorly by:
-> Govt. policy ie. setting base rates
- Investors’ view on the risk environment (views on specific assets as well as the general economy) :
-> Major determinant of appropriate prices are
acceptable to each investment
-> Supply and demand balance out to set prices
for the investments
Why do interest rates change?
- Government’s primary tool to control the economy is setting SHORT-TERM interest rates. In particular to control:
-> Economic growth
-> To control inflation (demand-pull inflation)
-> Cost of imports by controlling exchange rates
- Govt policy sets the base lending rate for central to commercial bank lending
How do changes in interest rates affect inflation?
- Short-term real interest rate increase => encouragement to save/ discouragement to borrow => reduction in consumer expenditure (demand) => decreased short-term economic growth rate => reduced upward pressure on prices
- Short-term real interest rate decrease => encourages spending/borrowing/general investment => increased short-term economic growth rate => increased upward pressure on general prices
- Notice the LAG between inflation and interest rates
How do changes in interest rates affect exchange rates? and what are the knock on effects on businesses?
- If interest rates are low in a country, investors are less inclined to invest in that country as oppose to others => reduced demand for domestic currency => weakened domestic currency
- Cost-push inflation for importing businesses because foreign goods appear more expensive & prices go up
- This is good for exporting businesses because overseas investors find goods more cheap and affordable
- This can be controlled by increasing interest rates
Decision making process for base rates set by central bank:
- Inflation and levels of economic activity influence base rate decisions:
-> If inflation appears as if it will “take off” base rates
- Mkt. supply & demand validates the rates set (or not) eg. if mkt. still keeps borrowing and inflation increases more, govt. may increase base rates further
- Central bank resets & adjusts if desired outcomes not achieved
What affects LONG-TERM interest rates?
- Mkt. supply & demand of bonds affect the rest of the yield curve (medium & long-term)
- Specific factors include:
–> Inflation long-term expectations
–> Government interventions
–> Risk management by investors eg. pension
–> Overseas rates, exchange rates
Govt influence on long term interest rates
- Set the price for govt. bonds at each duration
–> They can exercise muscle as dominant bond
- Quantitative easing, buying back gilts, reducing supply
to increase prices
- Communication -> announcements for short-term
interest rates over the medium term
What makes the price of an investment price elastic?
- Many alternative close substitutes for the investments
Which has primary influence on investment mkts supply or demand?
- Under most conditions, demand changes more rapidly than supply
-> Sudden change in legislation on how statutory
valuations are done wrt. gilts for instance
-> This could cause a sudden surge in demand for
What are the main factors affecting the demand for assets?
- Riskiness of the asset
- Need for fin. institutions to match liabilities
- Expected investment returns from holding asset
–> Is the increased risk of corp. bonds commensurate
with the added yield over gilts?
Supply, demand and hence the prices of bonds are driven by:
- INFLATION EXPECTATIONS and inflation risk premium
-> A sudden increase in inflation expectation
decreases bond prices => risk of A/L mismatch
- SHORT-TERM INTEREST rates BUT this is:
-> Basically uncorrelated with long-term bond yields
- BORROWING REQUIREMENTS
-> Private sector - for investment into businesses
-> Public sector - to raise money for public
- INSTITUTIONAL cashflow (pension schemes matching liab.)
- INTERNATIONAL context
-> Exchange rates
-> Foreign interest rates
- Returns on ALTERNATIVE investments eg. property may be particularly cheap
- Any economic VIEWS/ OPINIONS/ NEWS eg. covid
How does inflation affect bond prices?
- Investors buy bonds @ price which they expect will have a particular real return over inflation
- If current inflation expectations are higher in future, required yields will be higher @ the longer terms (investors require a particular maintained real return regardless of future inflation)
- Prices change right when the information comes out
- If inflation is higher than expected, demand for certain bonds will reduce because they do not provide required real returns (investors will not buy them).
- Investor views of inflation will have major impact on bond prices & the yield curve
Increased inflation expectations might lead to increase in unemployment rates. Why?
- Increase in inflation expectation => increase in interest rate expectation => savings expected to increase => reduced spending => reduced demand => less need for workers => reduction in wages by layoffs (otherwise company will make losses)
How do short-term interest rates affect bond prices?
- If base-rate increases, the short-term bond prices reduce in response because they are highly correlated with base-rates eg.
- > 1 yr & 2 yr prices highly correlated
- Longer term bonds further down the yield curve however eg. 10 yr are uncorrelated w short-term rates (empirically observed fact)
- Uncorrelated in the sense that 10yr bonds will react to the news, but whether they move up or down will be uncorrelated to the movement of the base rate
Effects of government borrowing on bond prices and interest rates:
- Taxes raised by govt might be insufficient to pay welfare benefits, build roads etc.
- The govt issues bonds to borrow money as a result
- Bond supply rises & their prices fall resulting in higher interest rates
Institutional cashflows effects on bond prices:
- If institution incomes rise, they will invest more in bonds, increasing demand and prices of bonds
- Change in investment strategy also affect bond prices similarly (de-risking strategies for pension schemes)
How may corporate bond and gilt prices/yields react to news of a recession?
- Investors who bought corporate bonds may choose to sell these in light of a recession to buy gilts which are more stable
- Because the company might go bust if nobody buys their products => investors lose all their money possibly
- Investors EXPECT lower profits from companies
- Demand for corporate bonds decreases => yield increases
- Demand for gilts increases => yield decreases
- The credit spread between the two yields increases
Factors affecting equity market levels:
- Expectations of FUTURE profits/dividends
- REAL level of EXPECTED economic growth (because equities are real assets not concerned with inflation)
- Employment figures are key indicators of real level of expected economic growth
- General level of business outlook:
- > Recession/boom
- > Uncertainty
- > Stability
What factors influence supply of bonds?
- Govt supply: Falling tax receipts and increased govt spending on public amenities leading to increased public sector borrowing => increased gilt supply => fall in gilt prices
- Corporate bond supply: Comparative attractiveness of raising money from debt or equity
- Attractiveness of interest rate environment: low yields mean cheap loans
How is the supply of shares be influenced?
Supply of shares can be from:
- Privatisation of govt. organisations eg. railways
- Initial Public Offerings
- Rights issues
- Offering of overseas shares on domestic exchange
Note: These are relatively minor effects
How is the supply of property influenced?
Supply of property can be significantly influenced by:
- Changes in planning law (councils agree to more building)
- Lower interest rates (lower cost to builders who will borrow, and also to potential house buyers)
- Lower building costs eg. steel prices
- Growing economy
- Change of use of property (if lease structure and planning law allows) eg. agricultural to housing, warehouse to flats, tear downs
Supply influences on “other” markets:
- Technological advances facilitating design of complex derivative instruments & fast computer trading increased the supply of derivative instruments
- Increased the range of derivative products
- New markets can emerge
Non-economic drivers of demand for assets:
- External context has changed even if investors’ view of assets remain unaltered
–> Investors’ incomes changing
–> Investors’ preferences changing (maybe due to tax
–> Competing assets becoming more favourably
- Investors’ views of asset’s risk and future returns have changed
Impact of investors’ incomes changing on demand for assets:
- If investors have more income => more to save
- More money passed onto insurance companies/ pension schemes/unit-trusts etc
- These institutions invest in more bonds/equities
- Companies may use their increased profits to support their DB pension schemes => large inflows to equity/bond markets eg. increased demand for long bonds by pension schemes
- Essentially more money all round to buy market assets so demand for them increases while the supply does not shift as much => price increases all round
Reasons for investors’ preferences changing on demand for assets:
- Changes in TAX regimes
- Changes in REGULATION eg. minimum requirement of bond investments in pension schemes, incentives to invest in green industries
- Changes in investors’ own LIABILITIES and matching required eg. LPI statutory req. to increase pension pmts by MIN(RPI% , 2.5%)
- EDUCATION of investors
- Uncertainty in POLITICAL climate
- JOURNALISTIC influences bidding up prices, fashion, mkt. sentiment, herd behaviour
Influence of competing assets on asset demand:
- Competing assets may become more favourably viewed
- > eg. Pension schemes bid up the value of long-term bonds to match their long term liabs and other investors see shorter corporate bonds as better value for money
Impact of a change in investors’ views on future risk & return of assets on demand for assets:
- Investor more concerned about risk and less optimistic about future returns
- Lots of close substitutes in most investment mkts
- > If company’s competitor is doing well, share price of the company can reduce
- > Respected CEO resigns
- > Political climate
- > Revised strategy for the future
- > Poor performance in recent years
What is a yield curve?
The yield curve is a plot of yields of zero coupon bonds against term to redemption of zero coupon bonds
Theories of the yield curve:
o Expectations theory – yields reflect expectations of future short-term interest rates and inflation
o Liquidity preference theory – investors require an additional yield on less liquid (longer-term) bonds
o Inflation risk premium theory – investors require an additional yield on longer-term conventional bonds to compensate for the risk of inflation being higher than anticipated.
o Market segmentation theory – yields at each term are determined by supply and demand at that term. Demand comes principally from institutional investors trying to match liabilities.
Theories of the real yield curve:
- Real yield curve is a plot of real GRYs on zero coupon index-linked bonds against term to maturity
- Difference b/w conventional yield curve & real yield curve is approx. the mkt expectation of future inflation