Download FNCE 3020 Spring 2004

FNCE 4070
FINANCIAL
MARKETS
AND
INSTITUTIONS
Lecture 4
The Behavior of Interest Rates
Foreign Cartoons: Interest Rates
Japan: 2006
Australia: 2008
Background on Cartoons
Japan: AA Corporate
Rates Compared to U.S.
Australia: Reserve Bank
Interest Rate Target
Explaining Interest Rates

There are two possible approaches to explaining the
behavior (i.e., movement) of interest rates:

(1) Demand and Supply models:



(2) Understanding (through empirical analysis) critical
variables that are likely to result in a change in interest rates:


(1) Model based on the demand for and supply of loanable funds
(i.e., debt instruments) in financial markets (Chapter 2 in the text).
(2) Model based on the demand for and supply of various debt
instruments (i.e., bonds) in the economy (See appendix 1 at end of
this lecture).
Variables, such as inflation (inflation expectations), business
cycles, central bank actions, safe haven effects.
These two approaches are also important because they can
be used to help us forecast interest rate changes.
Variables Affecting Interest Rates


The second approach to understanding the
behavior of interest rates is to understand the
critical factors that are likely to affect market
interest rates.
This check list-approach include:

The inflation relationship to interest rates.


The impact of business cycles on interest rates.



Irving Fisher Model of Interest Rates
Cyclical Model of Interest Rates
The impact of central bank monetary policy actions on
interest rates (especially on short term rates)
The impact of a financial crisis on interest rates (risk
aversion and flight to quality – safety -- issues).
Fisher Interest Rate Model



Concept developed by the American
economist Irving Fisher in his Theory of
Interest (1930)
Fisher’s interest rate model states that the
market rate of interest is the sum of
 (1) a real rate requirement.

The real rate requirement reflects
the reward that should accrue to the
lender for “lending to a productive
economy. “
 (2) the market’s expected rate of
inflation (i.e., an inflation premium).

This inflation premium protects
investors against this loss of
purchasing power.
So: Market interest rate = real rate
requirement + inflation expectations.


Irving Fisher (1867-1947);
Educated at Yale (Ph.D. in
economics in1891) and
taught at Yale from 1892 1935
A “classical” economist
known for:
 Equation of Exchange;
(MV = PT)
 Phillips Curve
 A visible index card
system - known today as
the rolodex
Fisher Real Rate Requirement


Defined: “The reward for lending into a productive
economy.”
Problem: This real rate requirement is much easier to
conceptualize than it is to actually measure.


Conceptually, however, it is probably related to growth theory,
with an economy’s growth dependent upon productivity of its
workforce and population.
So, while the real rate requirement cannot be observed,
different estimation methods relying on theoretical “growth”
models have suggested:


A range of 2-3% for both the United States and the euro area.
A rate of 3% for the United Kingdom

Sources: Manrique and Manuel Marques (2004), Laubach and Williams
(2003), Giammarioli and Valla (2003), Larsen and McKeown (2004)
Inflation - Interest Rate Model

For default-free securities we assume that:


Market rate = real rate requirement + inflationary expectations premium
The assumption is that of the two components, the real rate requirement
is relatively stable.



For securities with a default component (e.g., corporate bonds)
we assume:



Why? Productivity and population changes are not subject to major short term
fluctuations.
However, inflationary expectations can change dramatically over shorter time
frames.
Market rate = real rate requirement + inflationary expectations premium
+ default risk premium
Unlike default free securities, we also need to be aware of changes in
default risk premiums which will cause the observed interest rate on
these securities to change.
Observation: For default free securities (especially longer term
Treasuries),we tend to focus on inflationary expectations as the
major factor behind changes in market interest rates. While
inflationary expectations play a role in the interest rate structure
of non-default free securities, will also need to pay attention to
changes in default premiums.
The Fisher Effect in the United States: 1965 2011; Long Term Government Interest Rates
The Fisher Effect in the United States: 19652008; Short Term Government Interest Rates
Regression Results: 1954 - Present

R-Squares (monthly data):

CPI against 3-month T-Bill Rates: 49.17%
CPI against 20 year T-Bonds: 67.15%




F.F. Rate against 3-month T-Bill Rates: 97.49%
F.F. Rate against 20 year T-Bonds: 84.78%
F.F. Rate against 10 year T-Bonds: 78.78%
The Fisher Effect in the United States: 1965 - 2011;
Long Term Corporate (Aaa and Baa) Interest Rates
Regression Results: 1954 - Present

R-Squares (monthly data)

CPI against Aaa Corporate Rate: 41.69%
CPI against Baa Corporate Rate: 41.13%

Impact of Aaa Risk Premiums on Interest
Rates: 1965 - 2011
Impact of Baa Risk Premiums on Interest
Rates: 1965 - 2011
Regression Results: 1954 - Present





R-Squares (monthly data)
Aaa Corporate Rate against CPI: 41.69%
Aaa Corporate Rate against CPI and Risk of
Default Spread (Aaa – 10 Year T-Bonds):
46.02%
Baa Corporate Rate against CPI : 41.13%
Baa Corporate Rate against CPI and Risk of
Default Spread (Baa- Aaa): 63.00%
Do Risk of Default Ratings Matter?
Global Default Rates
Cumulative Default Rates, 1981-2005 (%): For
global and U.S. companies initially rated in
1980
Inflationary Expectations

What do you think influences inflationary expectations in an
economy?

Recent inflation data:


“Adaptive response” of market participants to current inflation data.
Forward looking data; how events now might affect future inflation:

Central bank actions (lag effects of policy changes).


Government fiscal policies.


Oil, food, etc.
Exchange rates impacting on import prices.


What’s happening to fiscal deficits.
Global demand/supply for key commodities and prospects for future
supplies.


What’s happening to the money supply and bank reserves.
How dependent is the country on critical imports?
Need to examine observed data in relation to some benchmarks.


Recent inflation data in relation to “explicit inflation” targets of governments
and central banks.
What the economy actually doing in relation to what it could be doing?

What is the economy’s output gap (actual GDP growth in relation to
potential GDP growth)?
Output Gap


Output Gap is a measure of the
difference between an economy’s
actual output and the output it could
achieve when it is at “full capacity.”
There are two types of output gaps:
positive and negative.


A positive output gap occurs when
actual output is more than fullcapacity output. Negative output
gap occurs when actual output is
less than full-capacity output.
The chart at the right shows the
estimated % output gap for the U.S.
economy from 1990 to the present.

A negative output gap is shown
below the 0 line. A positive output
gap, above.
U.S. Output Gap and Inflation:
1980 to 2007

Economic theory suggests
that positive output gap will
lead to inflation as labor
and production costs rise.



This is also a situation when
demand pull inflation is likely
to exists.
Findings: Every percentage
point by which real GDP
falls short of (or exceeds)
potential tends to reduce
(increase) the inflation rate
by about half a point over
the course of the year.
Source: Krugman, 2008
Extending the Model to Incorporate
Term to Maturity Considerations

The next step in our explanation of interest rates is
to incorporate maturity considerations in the model.




Generally, the longer the term to maturity, the greater the
potential risk (e.g., price risk).
To extend the Fisher model to consider maturity, we
add a maturity premium, or:
Market interest rate = (1) real rate requirement + (2)
inflationary expectations premium + (3) maturity
premium.
Where the maturity premium compensates for a
security’s exposure to interest rate risk (i.e., price
risk). Recall, the longer the maturity, the greater the
potential risk, hence the greater this maturity
premium.
Maturity Premiums on Government Securities
Rates on 1 Year, 10 Year
and 20 Year Treasuries

1962 – 2008



6.14%
6.98%
1993 – 2008




1 Year:
10 Year:
1 Year:
10 Year:
20 Year:


1 Year:
10 Year:
20 Year:


4.29%
5.42%
5.92%
2001 – 2008

Maturity Spreads Over
Time
 1962 – 2008
2.73%
4.42%
5.50%
1993 – 2008



10 Year: 84 Basis Points
10 year: 113 Basis Points
20 Year: 163 Basis Points
2001- 2008


10 year: 169 Basis Points
20 year: 277 Basis Points
Maturity Spreads Vary over Time:
Sometimes Negative
Extending the Model to Non-Risk
Free Debt Instruments

The final adjustment to this model
incorporates a default risk premium, or:


Market interest rate = (1) real rate requirement +
(2) inflationary expectations premium + (3)
maturity premium + (4) default risk premium
Where the default risk premium compensates
for the chance that the borrower will default.

The greater the “estimation” and “expectation” of
default, the higher this risk premium.
Historical Default Spreads
Aaa - Treasuries
 1993 – 2008




Default Spreads
 1993 – 2008
Aaa:
6.70%
30 Year Treasuries: 6.15%
20 Year Treasuries: 5.92%


2001 – 2008



Aaa:
5.82%
30 Year Treasuries: 5.09%
20 Year Treasuries: 5.05%

Over 30 Year Treasuries:
55 Basis Points
Over 20 year Treasuries:
78 Basis Points
2001 – 2008


Over 30 Year Treasuries:
73 Basis Points
Over 20 Year Treasuries:
77 Basis Points
Baa Risk of Default Spreads
Business Cycle Impacts on Interest
Rates


Question: How do interest rates generally move
over the course of a business cycle?
Historically, while we have observed that interest
rates have moved in a “pro-cyclical” manner
(i.e., they move with the business cycle), i.e.,

Rates moving down during a business recession.


Why do you think this is the case?
Rates moving up during a business expansion.

Why do you think this is the case?
Business Cycles and Short Term
Interest Rates
Business Cycles and Long Term
Interest Rates
Interest Rates in the Current
Business Cycle
Default Spreads Over the Course of
a Business Cycle

Default spreads are dependent upon the
business cycle and perceptions about the state
of the economy.



Rising during economic downturns and during periods
of increasing economic and financial uncertainty.
Falling during economic expansions and during
periods of decreasing economic and financial
uncertainty.
Default spreads influenced by the market’s
estimates as to future cash flows available to
support outstanding debt obligations.
Baa and Aaa Default Spreads and
Business Cycles
Observations on Relative Rate
Changes


Over time, short term and long term interest
rates tend to move in the same direction.
However, short term interest rates exhibit
more volatility than long term interest rates.


As measured in basis point changes over time.
Over time, however, prices on long term debt
instruments exhibit more volatility than prices
on short term debt instruments.

Confirming that there is more price (interest rate)
risk associated with these long term securities.
Relative Interest Rates Movements: Short
term Versus Long term Interest Rates
1900 – 1942 Corporate Bond Yield
Curve Data
Monetary Policy Impacts on
Financial Markets

In most countries today (and certainly in all industrial
countries), monetary policy uses as its main financial target
some key short term interest rate.




United States: Federal Funds Rate
Bank of England: Official Bank Rate
European Central Bank: Main Refinancing Rate
Bank of Japan: Uncollateralized Overnight Call Rate



View these interest rates at: http://www.bis.org/cbanks.htm
This managed key interest rate is used to achieve inflation
goals and other economic goals.
Issue for financial markets: How strong is the relationship of
this key interest rate to other market interest rates?

In major industrial countries, this relationship is very strong with the
key monetary policy rate producing almost immediate changes in
short term interest rates.
Bank of Japan’s Policy Impacts
Monetary Policy Reactions to
Business Cycles


Another issue is the response of central bankers to
business cycles.
Issue: Do they raise rates during expansions and reduce
them during recessions?


Answer: Generally Yes
Second issue: Are central bankers proactive or reactive to
business cycle changes?



Do they anticipate future economy activity and act in response to
their forecasts (proactive), or do they react as the economy
changes (reactive).
This would result in either central bank interest rates leading
economic activity or taking place at the same time or after the
business cycle turning point.
U.S. proactive. Other central banks present a mixed picture.
Response of U.S. Monetary Policy
to Business Cycles, 1965 - 2009
Federal Reserve and Three Cycles
Since 1990
Inflation Targeting and Monetary
Policy Induced Interest Rate Changes

An additional central bank issue occurs because of the
recent adoption of inflation targeting by many central
banks.




View these targets at: http://www.bis.org/cbanks.htm
Note: U.S. Federal Reserve adopted an “implicit” 2% long term
inflation target in January 2008.
Issue: As announced inflation targets are exceeded,
should we be on the alert for central bank interest rate
response.
Specifically, as inflation targets are exceeded, central
banks will probably raise their key short term interest rate to
slow the economy (demand) and ease inflationary
pressures back to their announced target.
Safe Haven Effects

The last issue to be explored is that of a safe
haven effect.



Investments in “safe haven” financial assets occurs
during periods of financial, economic, political, military
uncertainty.
The greater the uncertainty, the greater the demand
for “safe haven” financial assets.
Examples of safe haven financial assets:




Government securities (especially short term)
Key currencies (US dollar, Swiss franc)
Precious metals (gold, silver).
Increase safe haven demand will push up the prices of
these assets and in the case of government securities,
drive down their interest rates.
Safe Haven Effect: T-Bills

January 2007: 4.98%
December 2008: 0.03%
Safe Haven Effect: U.S. Dollar

Desert Storm begins: February 24, 1991
Safe Haven Effect: Swiss Franc

Percent Change in the U.S. Dollar (Note: CET = Central
European Time)
Appendix 1
Bond Market Model
This appendix discusses the demand and supply bond market model
which can be used to explain changes in the market’s equilibrium
interest rate
Bond Market Model


The bond market model uses a demand and supply
approach to illustrate how market interest rate changes
come about.
The model focuses initially on factors that will cause the
price of bonds to change.


The bond market model incorporates:



Since there is an inverse relationship between prices and interest
rates, the final step in the model relates to resulting interest rate
change from assumed demand and supply changes.
(1) a demand curve; which plots the relationship between the
market’s demand for bonds and the prices of bonds (holding all
other factors constant), and
(2) a supply curve; which plots the relationship between the
market’s supply of bonds and the prices of bonds (holding all
other factors constant.
Model assumes that at any point in time, these two curves
can be represented as follows (see next slide):
Demand and Supply Schedules

Bond Demand Schedule:

Demand
Assumes that as the price (P)
of bonds decreases, the
demand for bonds will increase
because as the price falls, the
yield will increase.



P
Bond Supply Schedule:

Supply
Q
Higher yields will increase the
demand to hold bonds.
Thus the demand curve is
downward sloping (left to right)
Assumes that as the price (P)
of bonds increases, the supply
of bonds will increase because
as the price rises, the cost to
borrow will fall.


Lower borrowing costs will
increase the supply of bonds
offered by borrowers.
Thus the supply curve is upward
sloping (left to right)
Equilibrium in the Bond Market

Bond Market Price
Equilibrium:

Demand

P
Supply
Also referred to as the
market clearing price
(which in turn produces a
market clearing interest
rate; or yield to maturity).

Q
This is the point where the
amount of bonds an economy
is willing to buy (i.e., demand)
equals the amount of bonds
an economy is willing to sell
(i.e., supply).
Think of the market clearing
interest rate as the economy’s
required return.
What Causes the Schedules to Shift?

Changes in the demand and/or supply schedule will
cause a change in the market’s equilibrium clearing
price (and thus in the market interest rate).

Demand Shifts Result From Changes in:





Supply Shifts Result From Changes in:





Overall financial market risk (resulting in safe haven effects and
risk aversion effects)
Wealth (or income) levels (impacting on investor portfolios)
Expected (relative) return on financial assets other than bonds.
Expected inflation (impact on real return to investors; e.g., the
higher the real return the greater the demand for bonds)
Government debt financing (expenditures – tax receipts)
Business investment decisions (business cycle effects and
expected profitability)
Expected inflation (impact on real cost of borrowing; e.g., the
lower the real cost the greater the supply of bonds)
Monetary policy (open market operations impact on supply of
bonds, specifically T-bills)
In addition, global factors need to be considered.
Changes in the Equilibrium Price
(and thus, Interest Rate) as Demand
Schedule Shifts
Demand
Price
Supply
Quantity of Bonds
Changes in the Equilibrium Price
(and thus Interest Rate) as Supply
Schedule Shifts
Demand
Price
Supply
Quantity of Bonds
General Bond Model Versus
Specific Bond Markets


The bond market model we have developed thus
far, is a general representation of the “average”
interest rate in the economy at a point in time.
In addition to this general representation, we can
extend the model to various segments of the bond
market to account for relative changes in interest
rates among a range of debt markets.


As one example, a move out of “riskier” corporate issues
into T-Bills, in terms of safe haven effects, and the resulting
impact on prices and interest rates can also be illustrated
through a “segmented” bond market model approach.
This is illustrated with the example on the next slide.
Impact of “Relative” Changes in Demand on
Interest Rates, September 2008

In September 2008,
uncertainly in financial
markets resulted in a flight
to safety and specifically
into T-bills and out of
commercial paper.



The increase demand for Tbills (schedule shifted out)
resulted in an increase in
their prices.
And as prices rose, their
yields fell.
In addition, markets
moved out of commercial
paper

This reduced the demand
for commercial paper,
driving down their prices
and pushing up their yields.
Reaction of Interest Rates (Yield Curve) to
Congress’ Rejection of Financial Bailout Package,
Key to Yield Curve: Orange yield
September 29, 2008
Curve is for Friday, September 26

th


and Green yield curve is for Monday,
September 29th.
On Monday, September 29, the U.S.
House of Representatives voted to
reject the Financial Bailout Package.
Dow Jones Industrial Average fell 777
points on Monday.




This represented a shift out of stocks.
One “demand” factor in the bond market
model are the returns in alternative
investments.
Investors moved into safe haven
financial assets as show in the yield
curve.
The drop in the yield curve (from
Friday to Monday) represented a flight
to safety (increase risk aversion) along
the entire maturity of government
securities.

Increase demand for Treasuries
(demand schedule moved out) drove up
prices and pushing down yields.
Reaction of Interest Rates (Yield Curve) to
Speculation Financial Bailout Package would be
Approved, September 30, 2008


Key to Yield Curve: Orange yield
Curve is for Monday, September 29th
and Green yield curve is for Tuesday,
September 30th
On Tuesday, the indications were that
Congress would pass the $700 billion
bank-rescue package (which had been
rejected the day before).


On Tuesday, the Dow Jones Industrial
Average increased 480 points (the most in
six years).
On Tuesday, the yield curve rose as
market uncertainty (and flight to safety)
eased from the previous day.

Reduced demand for Treasuries (demand
schedule moved inward), pushed down
Treasury prices, thus resulting in higher
interest rates.
Appendix 2
A Short Bio on Irving Fisher, adapted from:
http://www.econlib.org/library/Enc/bios/Fisher.html
http://economics.about.com/od/famouseconomists/a/irving_fisher.htm
http://www.answers.com/topic/irving-fisher
The Life of Irving Fisher

Irving Fisher was born in Saugerties, New York on February 27, 1867. He gained an eclectic
education at Yale, studying science and philosophy. He published poetry and works on
astronomy, mechanics, and geometry. But his greatest concentration was on mathematics
and economics, the latter having no academic department at Yale. Nonetheless, Fisher
earned the first Ph.D. in economics ever awarded by Yale. After graduation he stayed at Yale
for the rest of his career where he taught from 1982 to 1935.

Irving Fisher had many interests. Due to developing and surviving tuberculosis in his early
30s Fisher had a great interest in health and hygiene. He wrote a national best-seller titled
How to Live: Rules for Healthful Living Based on Modern Science. Fisher was also an
inventor. In 1925 his firm, which held the patent on his “visible card index” system, merged
with its main competitor to form what later was known as Remington Rand and then Sperry
Rand. This merger made his a very wealthy man. However, he lost a great deal of this wealth
(around $10 million) in the stock market crash of 1929. During his life Fisher also
campaigned for Prohibition of alcohol.

Although he damaged his academic reputation by insisting throughout the Great Depression
that recovery was imminent (he famously predicted, a few days before the Stock Market
Crash of 1929, that "Stock prices have reached what looks like a permanently high
plateau.“), contemporary economic models of interest and capital are based on Fisherian
principles. Similarly, monetarism is founded on Fisher's principles of money and prices (the
quantity theory of money). Fisher died in New Haven, Connecticut on April 29, 1947.
Appendix 3
Output Gap and Investment Strategy
Lombard Research, London
Stages Over Output Gap Cycles
Stages




Stage 1: Positive, with actual
rising faster than potential
Stage 2: Positive, with actual
still rising, but moving down
towards potential (the 0 line)
Stage 3: Negative, with actual
falling below potential (after
just crossing the 0 line)
Stage 4: Negative, with actual
still falling, but moving up
towards potential.
Stage 1
Stage 2
Stage 3
Stage 4
Output Gap and Investment
Strategy
Output Gap




Stage 1: Positive, with actual
rising faster than potential
Stage 2: Positive, with actual
still rising, but moving down
towards potential (the 0 line)
Stage 3: Negative, with actual
falling below potential (after
just crossing the 0 line)
Stage 4: Negative, with actual
still falling, but moving up
towards potential.
Investment Strategy




Phase 1 – common stock but
shifting to cash as interest
rates rise
Phase 2 – bonds as interest
rates fall
Phase 3 – remain in bonds,
shifting to common stock
towards the end of the phase
Phase 4 – common stock
Appendix 4
U.S. Business Cycles: Historical Data
U.S. Business Cycle Data
1902 – 2001 Recessions:
Average length 13 months
1973 – 2001 Recessions:
Average length 10.8
months