 |  Money and Capital Markets: Financial Institutions and Instruments in a Global Marketplace, 8/e Peter Rose,
Texas A & M University
The Impact of Inflation, Deflation, Yield Curves, and Duration on Interest Rates and Asset Prices
Chapter SummaryWhile theories of how interest rates are determined usually focus upon a single interest rate
in the economy, there are in fact thousands of different interest rates confronting savers and
borrowers every day. This chapter has focused our attention upon two major factors that
cause interest rates to differ from security to security and loan to loan: (a) inflationary expectations:
and (b) the maturity, term, or duration of a financial instrument. Knowledge of
these two important rate-determining factors is critical if we are to make intelligent saving
and borrowing decisions and understand how the money and capital markets work.
- One key factor affecting interest rates is expectations about inflation. If lenders expect
a higher rate of inflation to prevail during the life of a financial instrument they will demand
a higher nominal interest return before making a loan. The Fisher effect argues
that the expected nominal interest rate attached to a loan or security is the sum of the expected
real rate plus the inflation premium (or expected rate of inflation). Fisher believed
that the real rate would be relatively stable; therefore, changes in the nominal
interest rate were due largely to changes in inflationary expectations.
- More recent research suggests that the relationship between inflation and interest rates
may not be as simple as implied by the Fisher effect. For example, the Harrod-Keynes
effect suggests that changes in the expected inflation rate may result, not in changes in
the nominal rate, but changes in the real rate of return instead. Moreover, the economy
and the public’s spending and investment habits may significantly impact the linkages
between inflation and interest rates. For example, the inflation-caused wealth, income,
and depreciation effects argue that a rise in expected inflation can reduce the expected
real rate of return, causing the expected nominal interest rate to rise by less than the full
expected change in the rate of inflation. In contrast, the taxation of interest income may
force the expected nominal interest rate to increase by more than expected inflation so
that savers can protect their after-tax return.
- There is great controversy today surrounding the possible linkages between inflation
and stock prices. Rising inflation doesn’t necessarily lead to rising stock prices. The
stock-price impact from inflation may depend on nominal contracts—that is, whether
revenues and expenses are favorably or unfavorably affected by inflation as a result of
agreements having to do with such things as wages and salaries, goods sold to customers,
and borrowing costs. Inflation doesn’t affect all stocks the same way because
different businesses and individuals are involved in different nominal contracts shaping
their cash inflows (revenues) and outflows (expenses).
- This chapter has also emphasized the usefulness of the yield curve in explaining interest-
rate movements. The yield curve visually captures the relationship between the annual
rate of return on financial instruments and their term to maturity. Yield curves have
sloped upward most frequently in recent years, with long-term interest rates higher than
short-term rates. However, yield curves may also slope downward or become relatively
flat (horizontal).
- Why does the yield curve change its shape? The unbiased expectations hypothesis contends
that yield curves reflect predominantly the interest-rate expectations of the financial
marketplace. A rising yield curve suggests that market interest rates are expected to
rise, while a declining yield curve points to lower expected interest rates in the future.
- Other viewpoints on the yield curve stem from the liquidity premium, market segmentation,
and preferred habitat theories. For example, the liquidity premium view contendsthat the greater risk associated with longer-term financial instruments results in these
longer-maturity assets bearing higher average returns, giving an upward bias to the
slope of yield curves.
- The market segmentation and preferred habitat views of the yield curve suggest that the
supply of securities of different maturities available to investors can affect the yield
curve’s shape. For example, a sudden increase in the supply of longer-term financial instruments
may cause long-term security prices to fall and their yields to rise, tipping the
yield curve toward an upward slope.
- Regardless of which yield-curve theory may be valid, yield curves can play a key role
in the management of financial institutions, which borrow a substantial portion of their
funds at the short end of the maturity spectrum and lend heavily at longer maturities.
Yield curves can be used to help forecast interest rates, with upward-sloping curves implying
rising interest rates and downward-sloping yield curves implying falling interest
rates in the future.
- Yield curves may help identify underpriced or overpriced assets whose yields will lie
above or below the curve at any moment in time. Moreover, some security traders "ride
the yield curve," taking advantage of opportunities to sell short-term seurities bearing
the lowest yields and purchasing securities at longer maturity bearing higher interest
rates.
- In recent years financial analysts have become somewhat dissatisfied with one of the
two key factors making up the yield-curve relationship—the term to maturity or number
of months and years until a security is due to be retired. An alternative measure of the
maturity of a financial instrument—duration—has become popular in recent years because
it is a weighted average measure of the maturity or length of a financial instrument,
capturing both the size and the timing of all cash payments from an individual
income-generating asset or portfolio of assets. Duration has grown in popularity among
portfolio managers because it can be used, at least partially, to immunize a single asset
or an asset portfolio against changing market interest rates.
- Duration is also linked to the price volatility (or price elasticity) of a financial instrument
in a directly proportional way. Duration connects the percentage change in price
of a financial instrument to the change in its interest return or yield. Longer-term assets
tend to have longer durations and, therefore, greater price instability than do shorter-term
assets.
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2003 McGraw-Hill Higher Education