Reading 18: EoC Q 16&18 (bond yields)

CFA Level III Economics
#1

Hi everybody, I have two questions, one more general, the second specific to question 18.

In question 17 they look at teh effects of changes in business profits, central money suppy, gov. spending relative to tax receipts, etc.

In general one can state, that increases in GDP or in general a strong economy would be negative for corporate bond investors in that such economic growth and aggregate demand would place upward pressure on bond yields.

Why is the actually upward pressure on the bond yields? Because everybody wants to buy bonds and prices go up and therefore yields down, or because it is not as cheap to borrow money because…

Just would like to have an easy explanation.

with regards to q 18, if short term gov. rate (1month) is higher for the uk, the uk is favoured. but how do we now what the REAL rate is?

thank you very much for your inputs.

#2

1, Bond is hurt by inflation. The GDP growth is not just postive, it’s large - almost 9%. It’s hardly to say S.Korea is an emerging market. So the inflation concern will have a negative impact on the corporate bond market.

2, You don’t have to assume the real rate is rising. Think of Federal Reserve, when it lowers the rate, USD is depreciated and it benefits the exports. The central bank won’t raise rate when the economy is in downturn.

#3

GDP increasing strongly will result in inflationary pressures as unemployment falls below the natural non-inflationary rate and wages rise with subsequent price increases. Inflation is bad for bonds. Additionally when GDP rises quickly the government is liable to pursue counter-cyclical monetary policy and raise interest rates to cool down the economy and mitigate inflation, which is … bad for bonds

I don’t have question 18 in front of me so I don’t know what it’s asking.

#4

So does this mean increases in GDP adversely affects bonds via 2 channels?

[1]GDP increases->Inflationary pressure->Demand for bonds increases ->Bond prices increases/yield decreases?

[2] GDP increases -> tighten monetary policy -> increase interest rates -> Bond prices fall/yields increase?

ty

#5

Question 18 asks what the effect on the currency would be, so if the short-term rate is 5% for the uk and only 1.9% for canada.

one would see the currency in the uk appreciate. why? i just don’t get it, bc we dont really know what the real rates are in these countires?

#6

Question 18 asks what the effect on the currency would be, so if the short-term rate is 5% for the uk and only 1.9% for canada.

one would see the currency in the uk appreciate. why? i just don’t get it, bc we dont really know what the real rates are in these countires?

#7

Why are you so concerned about the real interest rate? Why not supply and demand?

#8

tulkuu

if the inflation rate is higher in one country than it is expected to depreciate. As in ques, int rate in UK is 5% & canada 1.9%. Assuming this a real rate we should expect GBP to appreciate but if it is nominal than? so we do need to have an idea about inflation rates. is in it?

#9

It’s a one-month short term rate, not a long term rate. PPP may not hold for such a short term - 1 month.

#10

In general, when short term rate rises, the currency appreciates in a short term because of demand(higher yield), but it could depreciate in the long term due to the inflation if nothing else changes.