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Chapter 14 Interest Rate: The Financial Magic Wand That Turns All Beings Upside Down (3)
In an economy, the real interest rate tends to be constant because it represents your actual purchasing power.

Therefore, when the inflation rate changes, the nominal interest rate—that is, the interest rate published on the bank's interest rate table—will change accordingly in order to balance the formula.The increase in nominal interest rate is exactly equal to the inflation rate. This conclusion is called the Fisher effect or Fisher hypothesis.According to Elvin Fisher, the nominal interest rate on a bond is equal to the sum of the real interest rate and the expected rate of price change over the life of the financial instrument.Conventionally, this is known as the Fisher effect, and it states that the nominal interest rate (including the annual inflation premium) is sufficient to compensate lenders for the expected loss in purchasing power of the money they receive at maturity.That is, the nominal interest rate required by the lender should be high enough to enable them to obtain the expected real interest rate, and the required real interest rate is the operating return of the real assets in the society plus the risk compensation given to the borrower.The Fisher effect means that if the expected inflation rate increases by 1%, the nominal interest rate will also increase by 1%, that is, this effect is one-to-one.It is for this reason that when prices rose in the early 90s, the People's Bank of China set a higher interest rate level, and even had a value-preserving subsidy rate; but now, when prices fall, the People's Bank of China cuts interest rates again and again. .

The Fisher effect shows that when the price level rises, the interest rate generally tends to increase; when the price level falls, the interest rate generally tends to fall.

Default Risk: Interest Rate Risk Reduces Returns
Citigroup once stated that as countries around the world cut their benchmark interest rates to zero, the risk of a country's credit default will replace the interest rate level as the dominant factor in determining the rise or fall of the country's currency.

Hart, a foreign exchange analyst and economist at Citigroup, believes that as countries gradually exhaust various monetary policy intervention tools, credit default swaps, a financial tool used to assess investment risks, will replace benchmark interest rates and become the currency of the 10 countries. The most influential reference tool for exchange rates.

Hart believes that the credit default risk of a sovereign country is not just a material factor for the currency. When the financing capacity of some sovereign countries is close to the limit, the country's debt repayment ability will be the focus of the market.

Since the collapse of Lehman Brothers in September 2008, the UK, Sweden and Australia have suffered huge losses on credit default swaps.According to the survey, the currencies of these countries are the worst performers since August 9.

Default risk refers to the risk that the security issuer will suffer losses if it cannot fulfill its previously promised interest payment or the obligation to repay the face value of the security when it matures. It is usually for bonds, which is an important factor affecting bond interest rates.

When a company suffers a huge loss, it is likely to delay paying bond interest, such as Chrysler in the 20s and Lehman Brothers in the material, and they are at great risk of default.A country's national debt is generally not considered to be at risk of default because the government can always raise taxes to pay off the debt.Such bonds with no risk of default are called default-free bonds.The spread between the spread on a bond that is at risk of default and a bond that is not at risk of default is called the risk premium, and it is the extra interest that people must earn to hold a risky bond.

When a company is more likely to default due to a large loss, the default risk of corporate bonds increases, leading to lower expected returns and more uncertain returns on corporate bonds.Asset demand theory holds that, assuming all other conditions remain unchanged, if the expected return rate of corporate bonds relative to bonds without default risk decreases and the relative risk increases, the popularity of corporate bonds will decrease, and the demand for them will decrease accordingly.

At the same time, relative to corporate bonds, the expected return on bonds with no risk of default rises, the relative risk decreases, and treasury bonds become more popular and demand increases.Then the risk premium on a bond with a default risk is positive and increases as the default risk rises.

Because of the risk of default, bond investors need to know whether the bond company defaults on the bonds it issued.Therefore, investment consulting companies will rate the quality of corporate bonds and municipal bonds according to the possibility of default, so as to provide investors with relevant default risks, which are vividly called speculative-grade bonds or junk bonds (junk bonds).But because of this, the interest rates on these bonds tend to be higher than investment-grade bonds, hence the name high-yield bonds.

How Economic Cycle Expansion Affects Interest Rates
During the expansion phase of the business cycle, the quantity of goods and services produced by the economy increases, so national income also increases.At this time, since companies have many more profitable investment opportunities, they are more willing to finance through borrowing.Thus, at a given bond price and interest rate, the amount of bonds that firms are willing to sell increases.This means that during the expansion phase of the economic cycle, the supply of bonds will increase.

The expansion of the economy also affects the demand for bonds.During the expansion stage of the business cycle, wealth increases rapidly, and according to the theory of asset demand, the demand for bonds also rises.So this will form a new state of supply and demand equilibrium, how will the interest rate change at this time?Historical actual economic data show that during the expansion stage of the economic cycle, the increase in the supply of bonds will be greater than the increase in demand. In this case, the expansion of the economic cycle and the rise in income will lead to an increase in interest rates.History shows that, in general, interest rates rise during the expansion phase of the business cycle and fall during the recession phase of the business cycle.This point has been confirmed in the development of many economies.

In July 2006, the Bank of Japan lifted the zero interest rate policy that had been implemented for more than five years and raised the interest rate to 7%.

Regarding Japan’s economic outlook, the central bank’s report stated that “the Japanese economy will continue to maintain a moderate expansion momentum.” The report also maintained the consistent rhetoric on prices last month, saying that consumer prices are increasing and core CPI will maintain an upward trend.The preliminary statistics released by the Japanese Cabinet Office on the same day showed that the Japanese economy grew by 0.2% in the second quarter of this year compared with the first quarter.

But the Bank of Japan said it also decided to keep the interbank rate unchanged at 0.4%.Because the Japanese economy is only in a stage of moderate expansion.

The business cycle is closely related to the money supply.Generally, during the expansion phase, the money supply increases accordingly; during the recession phase, the money supply decreases.Then, a relationship between money supply and interest rate can be obtained from this: when the money supply increases, the interest rate also increases, and when the money supply decreases, the interest rate also decreases.The so-called interest rate is actually the price of money. According to economic common sense, when the supply increases, the price decreases, and when the supply decreases, the price rises.So this conclusion seems to be uneconomical.Moreover, in the theory of liquidity preference, it can also be concluded that the growth of money supply will lower the interest rate.Which point of view is correct?
It's very important to figure this out.Because it contains very important policy implications.This determines whether the government will take measures to increase the money supply in pursuit of low interest rates.

Of all the effects, only the liquidity effect indicates that an increase in the growth rate of the money supply leads to a decrease in the interest rate.In contrast, the income effect, price effect, and expected inflation effect all suggest that increasing the rate of money growth raises interest rates.So, which one has the greater effect?How long can it last?
In general, liquidity effects that increase the rate at which the money supply grows have an immediate effect, because an increase in the money supply immediately lowers the equilibrium interest rate.However, increasing the money supply will take some time to increase the price level and income, and will have an effect on the interest rate.Therefore, it takes time for the income effect and the price effect to work.And expected inflation comes into play depending on how quickly people adjust their inflation expectations.It can be said that in the short run, the liquidity effect of the money supply will outweigh other effects, causing interest rates to fall.As time goes by, the income effect and price effect, as well as the expected inflation effect begin to appear, and the increase in the money supply rate will increase the interest rate.

Yield Curve: Judging Interest Rate Trends From Clues

Since the central bank raised interest rates in 2007, the yield curve of the bond market has shown a trend of flattening, and the flattening process of financial bonds is particularly obvious.

Before raising interest rates, the steepening degree of the yield curve of financial bonds was higher than that of treasury bonds. Since the short end of the yield curve of financial bonds rose more than that of treasury bonds, the steepness of the yield curves of the two tended to be similar.However, in the view of some analysts, since the rise in short-term yields has not yet been transmitted to government bonds, the risks in the bond market still have to be released.

Driven by strong demand, the medium- and long-term yields continued to fall, while the short-term yields rose to a certain extent under the influence of interest rate hikes, especially in financial bonds.However, if the rumors of the issuance of special treasury bonds to the market are true, further flattening may be hindered.

After the central bank raised interest rates for the fourth time in 2007, the short-term end of the financial bond yield curve, which is closely related to the central bank bill rate, also experienced a relatively large upward trend.China Bond Yield Curve shows that the yield of 1-year financial bonds has risen by about 10BP compared with the previous period.However, the rise in the yields of central bank bills and short- and medium-term financial bonds has not yet been transmitted to treasury bonds, and the yields of treasury bonds with corresponding maturities have changed little.

It can be seen from the materials that the central bank interest rate and the yield curve of the bond market are very closely related.And the complex relationship in the middle still needs careful analysis to understand one or two.

The rate of return refers to the investment rate of return of individual projects, and the interest rate is the general level of all investment returns.In most cases, the rate of return is equal to the interest rate, but the divergence between the rate of return and the interest rate often occurs, which causes capital to flow into or out of a certain field or a certain time, so that the rate of return moves closer to the interest rate.Bond yields do not necessarily move uniformly over a period of time, which may result in three types of yield curves: upward sloping, horizontal and downward sloping.

The yield curve is a basic tool for analyzing interest rate trends and market pricing, and is also an important basis for investment.When treasury bonds are freely traded in the market, different maturities and corresponding different yields form the "benchmark interest rate curve" of the bond market.Therefore, the market has a basis for reasonable pricing. Other bonds and various financial assets are based on this curve, and the appropriate price is determined after considering the risk premium.

When talking about interest rates, financial commentators usually say that rates are "going up" or "going down," as if all rates move in unison.In fact, if the bonds have different maturities, the interest rate trends will be different. The long-term interest rates can diverge from the short-term interest rates.Most important is the overall shape of the yield curve and what the curve says about the future direction of the economy or market.

Investors and companies who want to find clues about interest rate trends from the yield curve need to pay close attention to the shape of the curve.The Yield Curve is based on the yields you would earn on buying government short-, medium-, and long-term Treasury bonds.Through the yield curve, investors can compare the yields of various bonds according to the number of years they hold the bond until they get back the principal.

(End of this chapter)