Economics in the News Interest Rates Low but Fall Top-Rated Government Bonds Def
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Economics in the News
Interest Rates Low but Fall
Top-Rated Government Bonds Defy Gravity
The Financial Times,
June 20, 2014
When you hit rock bottom, the only way is up. One day that might apply to yields on the world’s safest and most liquid government bonds—U.S. Treasuries, U.K. gilts, German Bunds, and Japanese government bonds.
One day—but maybe not yet. Ten-year yields on core government bonds, which move inversely with prices, have edged lower in 2014—defying a near-universal start-of-the-year consensus that the only way was up.
German Bund 10-year yields this week hit a record low of just 1.12 percent. Ten-year U.S. Treasuries yields rose back above 2.5 percent on Wednesday on strong economic data but were 3 percent at the start of 2014.
Such historically meagre rates worry some investors. Low yields can already translate into negative real interest rates after taking account of inflation. If prices are in bubble territory, a correction could inflict heavy capital losses on bond portfolios.
Yields have already risen this year on two-year U.S. Treasuries and U.K. gilts, which track closely expectations about central bank interest rate moves.
Among strategists and analysts, it is hard to sense a bubble about to burst, however. “For there to be a bubble, there has to be irrational behavior,” says Steven Major, global head of fixed income research at HSBC. “I don’t see people borrowing to buy bonds—and I don’t think values are far from fundamentals.”
Instead, core government bonds offer havens in still-uncertain times—Russia’s tensions with the west are escalating—while yields are held in check by ultra-loose central bank monetary policies and a global glut in savings.
Low yields also reflect global economic prospects. From Japan to the eurozone, growth remains weak. While U.K. gilts in particular may be vulnerable to sudden changes in interest rate expectations, it is arguably too early to claim the U.S. and U.K. recoveries will be sustained.
“We are unlikely to see U.S. bond yields rise in isolation; we should expect a synchronised move higher once the global economy is fully recovering,” says Zach Pandl, portfolio manager at Columbia Management. …
Copyright The Financial Times Limited 2014.
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Essence of The Story
Interest rates on government bonds fell during the first half of 2014.
The interest rate on a German government 10-year bond was at a record low of 1.12 percent and the rate on a 10-year U.S. government bond fell from 3 percent to 2.5 percent during the first half of 2014.
Real interest rates could become negative.
When interest rates rise, bond prices will fall.
Economic growth is weak in Japan and Europe, and it is uncertain whether the U.S. and U.K. expansions will be sustained.
Economic analysis
The news article reports that the interest rates on government bonds fell during 2014 from an already low level and bond prices increased.
Government bonds, called Treasuries in the United States, gilts in the United Kingdom, and bunds in Germany, are the safest securities in the loanable funds market.
They are also easily traded, so they can be sold at a moment’s notice, which makes them highly liquid.
Because they are safe and liquid, government bonds have a lower interest rate than corporate bonds—bonds issued by corporations.
Although the level of an interest rate depends on the safety and liquidity of the security, interest rates, on average, move up and down together and are influenced by common forces that change the supply of and demand for loanable funds.
Figure 1 shows the interest rate on U.S. government 10-year bonds from 2010 to mid-2014 (both the nominal rate and the real rate.)
The striking feature of this graph is that although the interest rate was low in 2014, it was not as low as it had been in 2012, when the real interest rate was close to zero for two years and briefly negative at the end of 2012.
The news article says that the falling rate in 2014 risks making the real rate negative again, but that would require a full 1 percentage point fall in the nominal interest rate or a 1 percentage point rise in the inflation rate.
The news article says that the interest rate on U.S. government bonds fell from 3 percent to 2.5 percent per year. With inflation constant at 1.4 percent per year, these numbers translate to a fall in the real interest rate from 1.6 percent to 1.1 percent per year.
Figure 2 illustrates why the real interest rate fell. In January 2014, the demand for loanable funds was DLFJan and the supply of loanable funds was SLFJan . The equilibrium interest rate was 1.6 percent per year.
During 2014, the factors described in the news article increased the supply of loanable funds to SLFJun .
A key influence on the interest rate is missing from the news article: In 2014, the German, U.S., and U.K. government budget deficits shrank, which decreased the demand for loanable funds to DLFJun .
With an increase in supply and a decrease in demand, the equilibrium real interest rate fell from 1.6 percent to 1.1 percent per year.
The news article speculates that bond prices will fall and interest rates will rise as economic expansion increases the demand for loanable funds.
After you have studied Economics in the News on pp. 174–175, answer the following questions.
a.Why does the news article say that bond prices and interest rates move in opposite directions? Is it correct? Explain.
b. How does a government budget deficit influence the loanable funds market and why does a decrease in the deficit lower the real interest rate?
c.When an economic expansion gets going, what happens to the demand for loanable funds and the real interest rate?
d. If an expanding economy increases government tax revenue, how will that affect the loanable funds market and the real interest rate?
e. Looking at Fig. 1 on p. 175, what must have happened to either the demand for or the supply of loanable funds during 2011, 2012, and 2013?
Explanation / Answer
An easy way to grasp why bond prices move opposite to interest rates is to consider zero-coupon bonds, which don't pay coupons but derive their value from the difference between the purchase price and the par value paid at maturity.
For instance, if a zero-coupon bond is trading at $950 and has a par value of $1,000 (paid at maturity in one year), the bond's rate of return at the present time is approximately 5.26% ((1000-950) / 950 = 5.26%).
For a person to pay $950 for this bond, he or she must be happy with receiving a 5.26% return. But his or her satisfaction with this return depends on what else is happening in the bond market. Bond investors, like all investors, typically try to get the best return possible. If current interest rates were to rise, giving newly issued bonds a yield of 10%, then the zero-coupon bond yielding 5.26% would not only be less attractive, it wouldn't be in demand at all. Who wants a 5.26% yield when they can get 10%? To attract demand, the price of the pre-existing zero-coupon bond would have to decrease enough to match the same return yielded by prevailing interest rates. In this instance, the bond's price would drop from $950 (which gives a 5.26% yield) to $909 (which gives a 10% yield).
Now that we have an idea of how a bond's price moves in relation to interest-rate changes, it's easy to see why a bond's price would increase if prevailing interest rates were to drop. If rates dropped to 3%, our zero-coupon bond - with its yield of 5.26% - would suddenly look very attractive. More people would buy the bond, which would push the price up until the bond's yield matched the prevailing 3% rate. In this instance, the price of the bond would increase to approximately $970. Given this increase in price, you can see why bond-holders (the investors selling their bonds) benefit from a decrease in prevailing interest rates.
When there is defict in budget i.e expenditures are more then revenues the loanable funds available in the market gets decreased . The banks will lend only at higher rate of intrest.Decrease in deficit decrease the rate of inflation which decrease the real rate of intrest.
During economic expansion loanable funds increased beacuse of higher business acitivities. and real rate of intrest increases because of increasing nominal intrest rate.
Increasing tax revenue will decrease burden of loans and governemnt will now generate funds through taxes .As a result real rate of intrest decreases.
Figure is not available.
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