Inflation, Interest Expectation and Asset Prices
When Interest rates go down, bond prices go up. Almost all MBA students will tell you this. However many of them will be parrotting this without understanding what this means.
Let us see what actually happens.
When Interest rates go up, ASSET prices go down. This is the originally correct statement. Why and how does this happen?
Well let us make some assumptions:
Savings bank account interest rates are capped at 4% p.a.
Let us assume that the retail investors have a choice of investing in
a) Bonds – to get interest and bond value at maturity. (expected yield say 7%p.a)
b) House – to get rent and a decent price after a few years at a premium. (exp yield 9% p.a.)
c) Gold – no cash flow, but decent appreciation at the end of the holding period. (e,y. 12%)
d) Equities – dividends and decent appreciation at the end of the holding period. (exp yield say 3% div and 12% appreciation)
Now if the interest rate changes to say 6% in the savings bank account..what happens?
Well,
a) Bonds – to get interest and bond value at maturity. (expected yield say 9%p.a)
b) House – to get rent and a decent price after a few years at a premium. (exp yield 11% p.a.)
c) Gold – no cash flow, but decent appreciation at the end of the holding period. (e,y. 14%)
d) Equities – dividends and decent appreciation at the end of the holding period. (exp yield say 3% div and 15% appreciation)
When my YIELD expectation changes, it means I am willing to pay a LOWER price for the Asset.
Take an example if there is a bond with a coupon of 7% which I had bought at PAR…and the interest rate changes from 4% to 6% in sb account, people will not be able to (or will not be in a mood to) pay Rs. 100 for this bond, they would rather pay less. Surely you can REALIZE that the YIELD can be IMPROVED only by reducing the price that they pay for buying the bond!
The same thing applies to all other asset classes also.
Why do we then say ONLY ‘Bond prices go up when Interest rates go down’ and vice-versa?
Simply because in case of bonds we know the a) amount of interest that we are receiving AND b) the maturity date of the bond.
SO it is easy to say EXACTLY by how much the bond prices will move (that word is Duration – interest rate sensitivity). However all asset classes exhibit the same tendencies.
When interest rates are so low, Bond investors are BOUND to lose money in the long run of say 2-10 years. In case of gold their expectation will go up, and the same will happen in real estate and equity also.
Hey with a rising inflation, be ready for RISING interest rates too in India.
PR
Well explained..another way to look at this phenomenon is..
Interest rate in the savings bank account is viewed as the risk-free or ‘certain’ return. This becomes the minimum expectations of the investor. Accordingly, the expectations from the other assets are formed based on the risk involved in the asset. Higher the risk exposure in the asset, higher the expectations (e,y. here)
Now, if there is an increase in the interest rate, the other asset start looking LESS attractive and the GAP between the e,y. of Bank SB and e,y. of other assets gets adjusted to increase the e,y. of other assets. In other words, the reward for taking risk in other assets becomes LESS attractive, thus, the expectations increase corresponding to the risk perception of the investors.
Finally, this e,y. is used to discount future cash flows from the assets. And if discounting rate increases the PV (present value) decreases.