The bond market is watched closely by professional traders in the equity markets. The “smart money” often uses the bond market as a predictor of what will happen in the share market. One reason is because it can give indications as to where the economy is going. For example, high interest rates can be a negative for share markets, as we wrote about in our blog “Why rising bond yields is bad news for the stock market”.
Predicting the Economy
Short term rates are set by central banks. They evaluate different economic indicators before setting this rate. We wrote up on what the RBA analyse before making these decisions in tan recent article titled 7 Factors the RBA Uses to Evaluate Interest Rates.
Long term interest rates are determined by the market. The bond market will determine whether they think the central bank has acted appropriately given the current economic environment. If the bond market thinks the central banks have set the interest rates too low then there will be expectations of increased inflation. This will cause long term interest rates to increase to reward bond investors for the loss of purchasing power associated with the future cash flow. If bond investors think the central banks have set the interest too high, then long term interest rates will decrease as there will be expectations of decreasing inflation.
A normal yield curve shows low yield for shorter maturity bonds and higher yields for longer maturity bonds. There is greater probability that interest rates will rise with longer term bonds than shorter term bonds and hence yields become higher as maturity is longer. Interest rate rises negatively impact bond prices.
A flat yield curve depicts short and long term yields being similar to each other. In this case, the difference between yields on short and longer term bonds decreases. This “flat yield curve” term has been frequently mentioned in the media lately as it can indicate anticipation of slower economic growth.
The flattening of the yield curve may be caused when the central bank raises short term rates. When the central banks see the economy overheating then they may decide to increase rates to slow down the pace. As investors are uncertain about the economic outlook, they demand similar yields from long and short term bonds.
Investor Confidence in Government Debt
Bonds prices also indicate investor confidence in the country’s ability to repay debt. Bonds are a debt instrument where the government borrows money and compensated the investor by interest payments through out the life of the bond and the repayment of the loan at the end. Recently Italian yields were the highest in five years indicating that the government had to pay a higher interest rates to investors. This was to make up for the political instability that was occurring in the country. The yield on a bond can indicate how risky a bond is. For example, 10 year bond yields in the US are 2.94% but 10 year bond yields in Brazil are 12.10%. These figures indicate that investors are compensated with higher interest rates when buying a bond in a country which has a higher probability of defaulting.
Lauren Hua is a private client adviser at Fairmont Equities.
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