Short-term interest rates are determined largely by government policy, as the government balances… (3)
- the need to control inflation
- the need to encourage economic growth
- management of the level of the exchange rate.
6 Main factors affecting bond yield
- Inflation
- Short-term interest rates
- Institutional cashflow
- fiscal Deficit
- Exchange rate
- Returns on alternative investments, both domestic and overseas
Level of the equity market is determined by ….
investors’ expectations of future corporate profitability and the value of those profits.
Main influences on the level of equity (5)
- expectations of real interest rates & inflation
- the real level of economic growth in the economy
- investors’ perceptions of the riskiness of equity
investment - equity risk premium (ERP)
- expectations of currency movements
Other factors influencing the level of equity in the market (6)
- POLITICAL climate
- ALTERNATIVE investments
- TAXATION
- institutional cashflow
- OVERSEAS equity markets
- SUPPLY factors
How does demand and supply affect price?
What is the demand elasticity for most investments and why?
- Increase demand => Increase price
- Increase supply => Decrease price
- Demand for most investments are very price elastic due to the existence of close substitutes
Key economic factors affecting the property market
- economic growth
- real interest rates
- inflation
- institutional cashflow
- exchange rates
Inelastic supply of property is caused by: (5)
- time required to develop new properties
- planning permission rules and the limited physical space in some areas
- fixity of location
- high transaction costs
- segmented markets
Inflation effects on bond yield
-Inflation erodes the real value of income and capital
payments on fixed coupon bonds.
-Expectations of a higher rate of inflation are likely to
lead to higher bond yields and vice versa
Short-term interest rate effects on bond yields
Yields on short-term bonds are closely related to returns on money market instruments so a reduction in short-term interest rates will almost certainly boost prices of short bonds.
Investors in long bonds may interpret a cut in interest rates as a sign of monetary easing, with potentially inflationary consequences over the longer term. so the yield on long bonds might decline by a smaller amount, or even rise.
Fiscal deficit effects on bond yields
If the government’s fiscal deficit is funded by borrowing, the greater supply of bonds is likely to put upward pressure on bond yields, especially at the durations in which the government is concentrating most of its funding.
Full funding policy
-The government tries to meet the whole of the deficit
through borrowing.
-The alternative to full funding is to print money.
2 Components to returns from investments in a foreign country
- return achieved by the investment as measured in the
local currency - profit/loss from exchange rate movements
Institutional cashflow effects on bond prices
-If institutions have an inflow of funds because of
increased levels of savings, they are likely to increase
their demand for bonds.
-Changes in investment philosophy can also affect
institutional demand for bonds.
2 Important effects of real interest rates on the equity market
- Low real interest rates should help to stimulate
economic activity, increase the level of corporate
profitability, and hence raise the general level of the
equity market. - Rate of return required by investors should be lower,
so the present value of future dividends will be higher.
Inflation effect on equity market
-Equity markets should be reasonably indifferent
towards high nominal interest rates and high inflation.
-If the rate of inflation is high, the rate of dividend
growth would be expected to increase in line with the
return demanded by investors.
3 Indirect effects from inflation
- It might be argued that high interest rates and high inflation are unfavourable for strong economic growth, so fears of inflation will have a depressing effect on equity prices
- Investors expecting high inflation may also expect the government to increase real interest rates in response.
- Uncertainty about future inflation would make investors more nervous about fixed-interest bonds. Might result in an increase in equity investment, as equities should provide a hedge against inflation.
Equity risk premium
Additional return that investors require from equity investment to compensate for the risks relative to the risk-free rates of return.
Effects of a weaker domestic currency
- makes exports more competitive (increase profits, and profits earned in other countries are more valuable when converted)
- makes imports more expensive (bad for corporate profits to the extent that firms cannot pass higher costs of imported raw materials to customers)
- Higher costs of imported materials may lead to inflation, (however, if manufactured imports are more expensive, the domestic market share should increase)
Areas of economic influence on the property market (3)
- occupation market
- development cycles
- investment market
occupation market
demand for property for occupation by businesses
development cycles
supply of newly completed property developments
investment market
supply and demand for properties as investments.
Property: Effects of Development time lags
Peak of the property development cycle does not coincide with the peak of the business cycle.
time lag between gaining consent for a property development, and completing the construction on it, frequently results in a substantial amount of the supply of stock coming into the market as the economy slows down.
A slow down in the economy, coupled with rising real interest rates, is harmful to the property development industry.
Characteristics affecting supply/demand for the property occupation market
- fixity of location
- high transaction costs
- segmented markets
Cost-push inflation
Refers to a situation if firms’ costs go up, they will tend to pass on at least part of the increase to consumers through higher prices.
The average price level can be “pushed” up by an increase in costs.
3 Possible sources of cost-push inflation
- higher import prices due to a weakening of the domestic currency
- higher import prices for some other reason (eg rise in the oil price)
- higher wage demands not met by productivity increases
Quantity theory of money: Identity
M x V ≡ P x Y
- M is the nominal money supply
- V is the velocity of circulation
- P is the price level
- Y is the number of transactions
Quantity theory of money: Interpretation
If we assume that V (velocity of money) and Y (number of transactions) are fixed - as may approximately be true in the short run - then the quantity theory of money suggests that:
an increase in the (nominal) money in circulation will cause an increase in prices.
Demand-pull inflation
Refers to a situation in which there is excess demand with the economy so that firms are able (and more likely) to increase their prices.
As a consequence, the general level of prices may be pulled up.
3 Distinct ways in which increases in short-term interest rates can influence yields on either short- or long-dated bonds
- Higher short-term interest rates directly increase short-term bond yields because they should always be similar to each other.
- Expectations of higher future short-term interest rates can increase long-term bond yields according to the expectations theory of the yield curve.
- Higher short-term interest rates can reduce inflationary expectations and so tend to reduce long-term yields.
Why does selling Treasury bills increase short-term interest rates?
To sell more Treasury bills, the central bank needs to reduce their price.
This increase in their “discount” corresponds to a rise in one of the measures of short-term interest rates.
Rates on other money market instruments will move broadly in line.
Why selling Treasury bills might cause bond yields to rise
To sell more Treasury bills, the central bank needs to reduce their price.
This makes Treasury bills seem relatively attractive compared with bonds.
Bond prices may subsequently fall and yields rise.
Why printing money results in lower short-term interest rates
More money in circulation makes more money available for placing on short-term deposit.
It is therefore easier for banks to attract deposits.
Consequently, they can reduce interest rates on deposits.
Why printing money increases expectations of inflation
The quantity theory of money tells us that there is a direct relationship between the money supply and the level of prices.
More money chasing the same quantity of goods must cause prices to rise.
Why printing money causes bond yields to rise.
The increased expectations of inflation will make investors demand higher nominal yields in order to maintain the required level of real yields.
Expectation theory
Describes the shape of the yield curve as being determined by economic factors, which drive the market’s expectations for the future short-term interest rates.
Liquidity preference theory
Based on the generally accepted belief that investors prefer liquid assets to illiquid ones
Investors require a greater return to encourage them to commit funds for a longer period.
Inflation risk premium theory
Inflation risk is greater in the long term so yields should be higher than expected for long-dated stocks
Market segmentation / Preferred habitat theory
Yields at each term are determined by supply and demand from investors with liabilities of that term, so yields on short and long bonds may therefore move somewhat independently
Demand for an asset will change in 1 of 2 circumstances
- Investors’ opinions of the characteristics of the asset remain unchanged but external factors alter the demand for that asset. These external factors include:
• Investors’ cashflows
• Investors’ preferences
• The price of other investment assets - Investors’ perceptions of the characteristics of the assets, principally risk and expected return, alter.
