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Interest rates and inflation are important financial concepts, particularly when bonds are involved, but do you know how they are related and affect each other? Here we will go over each and why they are important.
Bonds are fixed-income securities that allow entities or ‘issuers’ to raise capital via borrowing from investors and promising to repay the bondholder at a later date. There are government bonds where the issuer is the government and corporate bonds where the issuer is a company.
A bond represents a stream of future cash payments, and when the bond matures, the principal is returned from the borrower (the issuer) to the lender (the investor). The cash flows are known as the ‘coupon rate’, and they are the nominal amount that is paid as a cash flow for each relevant period. While bonds may be initially issued at a certain rate of return, they can be resold on the secondary market, better known as the bond market, wherein the yield will vary based on the price decided by the open market.
Interest rates are set by central banks, such as the Federal Reserve (or the Fed) in the US. These rates set the cost of borrowing and the return on savings accounts within a country. Central banks adjust these rates to manage inflation, control the money supply, and support economic growth. During economic downturns or recessions, central banks usually lower interest rates to encourage borrowing and stimulate spending, with the hope of spurring growth. Conversely, in times of economic growth or high inflation, the central bank might increase rates to curb excessive spending and borrowing, generally slowing things like demand-pull inflation.
Inflation is the increase in price levels of goods and services within an economy over time, sometimes termed as an erosion of purchasing power. Although some inflation can be beneficial, as it encourages spending over saving, which usually causes economic growth, excessive inflation can harm an economy. Therefore, it is common for countries to keep track of their overall price levels using a Consumer Price Index (CPI): a weighted basket of goods that average consumers in a given country are likely to buy. The CPI measures the change in the overall price of this basket of goods, and the percentage change over time in the CPI is used to determine the inflation rate for a specific period, usually yearly, monthly, or both. Typically, central banks will have an 'inflation target' that they aim to keep inflation at through changes in interest rates. The Fed, for example, currently has a 2% inflation target.
Interest rates and inflation have an inverse relationship, and changing interest rates is how central banks generally control/manage inflation. When interest rates are lowered, inflation tends to rise, and when interest rates are raised, inflation usually decreases. This is due to lower interest rates making money, and therefore consumption, cheaper, which increases overall economic demand as everyone effectively has more access to money to purchase goods and services. However, it does not immediately create a corresponding increase in factors of production. This results in higher prices, known as 'demand-pull' inflation. Conversely, when interest rates are raised, consumption and investment become effectively more expensive because the cost of borrowing money is now more expensive. Consumption is also discouraged as higher interest rates incentivise saving over spending, as saving now has a higher rate of return. These factors reduce overall demand in the economy, therefore, slowing inflation. However, central banks like the Federal Reserve must also carefully balance inflation with other macroeconomic factors when deciding interest rates, such as unemployment.
Interest rates and bonds are inversely correlated, meaning they move in opposite directions to each other. If interest rates go up due to market dynamics or central banks, newly issued bonds offer higher yields to mirror these rates. As a result, existing bonds with lower yields become comparatively less attractive. This reduction in demand causes the prices of these existing bonds to decrease to offer a more competitive yield to potential buyers. On the contrary, when interest rates decrease, existing bonds with higher yields become more attractive than newly issued bonds with lower yields. This increase in demand drives up the prices of existing bonds. Therefore, investors need to understand this inverse relationship, as changes in interest rates can significantly impact the value and yield of bonds in their portfolios.
Bond investors are heavily affected by inflation, as it slowly erodes the purchasing power of money, affecting bonds negatively because they are fixed-income and the future income streams do not vary to reflect inflation. As inflation increases, the real value of the fixed interest payments and the value of the principal amount received at the bonds’ maturity date decreases. Therefore, the real yield (the bond's yield adjusted for inflation) may become less attractive. Higher inflation can cause central banks to raise interest rates to combat rising prices, further depressing bond prices due to the inverse relationship between interest rates and bond prices. Consequently, bonds tend to perform poorly in inflationary environments, which makes them less appealing to investors who want to preserve or increase their real wealth.
Bonds, Interest rates, and Inflation are all intermingled, and understanding each is important for understanding the overall economy and financial markets (whether you are directly invested in fixed-income securities) as they have ripple effects on the overall market and, therefore, other assets.
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