Market Influences |
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On this page This page discusses market influences on fixed income investment. Interest-rate movements have a direct impact on the valuations of fixed income securities. Interest rates are affected by a number of factors, each of which has to be taken into consideration when investing in fixed income assets. There are also influences that affect the interest-rate market as a whole; for example, changes to a country’s economic fundamentals will have an impact on the entire interest-rate market. Rate of Supply Domestically the fixed income asset class is directly affected by the government’s economic policy. The government’s stance on fiscal policy determines the underlying rate of supply of government bonds in the market and in turn the underlying rate of supply of semi government bonds in the market. Periods of high growth also mean corporate expansion and spending, which will impact on the supply of corporate paper to the market. The Reserve Bank of Australia has been extremely successful in managing the Australian economy over the last decade. The RBA can influence the economic performance by tightening or easing monetary policy at the appropriate time. Adjustments are made as economic indicator trends peak and trough during the business cycle. Economic factors affecting interest rates Inflation is a key determinant of interest rates. Expectations of future levels of inflation will cause bond prices to move in anticipation. If inflation expectations increase then interest rates will move higher. An increase in inflation means that an investor will need to receive a higher return to compensate for the reduction in purchasing power of his or her income. The opposite is also applies. The RBA implements monetary policy to ensure that inflation is kept within a reasonable range. Currently, that range is 2 to 3 percent per annum. As inflation expectations creep up the RBA will tighten monetary policy to slow inflationary pressures, such as increased consumer demand. Inflation can also be deemed to be too low. This has implications for fixed income as well. Deflation will mean lowering of fixed income yields. The balance of payments, which is the difference between receipts and payments to and from offshore counterparts, can also influence interest rates. If the balance of payments is seen to be deteriorating, foreign investors will demand a higher return (in the form of interest rates) for taking the additional risk of investing in this country. As the balance of payments moves into deficit it will erode GDP which will impact on the economic performance of the country and its ability to service foreign debt. These dynamics can be directly applied to borrowing-level movements for individual corporations on a micro scale. Australia also has to compete with countries of similar credit standing to attract foreign investment. Interest rates can make investments to other countries, with similar economies, more favourable when Australian rates are comparatively low and can attract funds to Australia when they are comparatively high. Therefore if interest rates are too high the Australian dollar will be well bid and conversely if they are too low the currency will be well offered. Australian interest rates are highly correlated to interest rates in the USA. The USA economy is a major driver of world growth. Changes to global economies will impact directly on Australian interest rates. A good example of the impact of foreign economies was the Asian meltdown in 1997/98. This had the effect of lowering interest rates around the world to compensate for the lack of demand coming from this region. All of these things will cause interest rates to rise or fall depending on the performance or impact of each going forward. If an investor wishes to exit a bond holding prior to maturity, or wishes to actively trade the fixed income market they need to be acutely aware of the impact of adverse and favourable economic developments. It is impossible to predict one-off events like the Asian meltdown, but investors can minimise risks by having an understanding of the dynamics of the fixed income asset class. Technology Technology in the modern economic environment has greatly enhanced the investor’s ability to access different markets. With the globalisation of Australia’s markets and the emergence of industries such as funds management, the investor now has far greater access to these investment opportunities and associated economic information. As a result, global markets are more interlinked than ever before. For example, in the process of managing superannuation investments, funds are allocated into equities, fixed income and property and then split into domestic and international percentages. As a country’s economic performance changes, so does the percentage of the particular investor’s holdings. This process in turn affects the country’s interest rates, equity levels, currency and so on. Other influences Other influences can affect individual issues or issuers, for example an increase in a particular corporation’s profits will improve its ability to borrow money from the market and thus the interest rate at which they can borrow will be lower. This type of market influence is further investigated in the credit rating section of this site. Unexpected adjustments to credit ratings can also affect the underlying security of countries’, states’ and corporations’ debt issuance. See our Credit Ratings page for a full discussion of ratings in the context of fixed interest investment. |