“When growth and inflation are primarily driven by aggregate supply, nominal bond returns tend to be positively correlated with growth, necessitating a higher term premium.”
Why does this lead to higher term premium and not lower?
Read the whole paragraph.
“In theory, assets earn a low (or negative) risk premium if they tend to perform well when the economy is weak.”
Here you have a situation where asset is performing well with growth -“positively correlated with growth” - and therefore a higher premium
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I must have missed that text, thank you Mikey!
Hi Mickey, I read that bit, but still dont get it:
- Is increase in aggregate demand sign of economic weekness while increse in aggregate supply sign of economic strength?
I assumed increase in either is a sign of strength but increase in supply would lead to lower inflation and presumably lower term-premia…(?)
No.
Not sure who much economics background you have or if you did Level1 before they took aggregate demand and supply out of syllabus.
This is hard without diagrams. but either draw them or imagine them.
Leave Aggregated demand (AD) un changed. Aggregate Supply (AS) contracts. The supply curve moves up to the left. We have stagflation. GDP is weak and inflation is high. Inflation high. Inerest rates high and bond prices do badly (1970s oil shock). AS increases the supply curve moves down to the right. GDP expands and prices fall. inflation low. Low inflation risk, interest rates low, bind prices ok. (early 2000’s as China moved into global supply chain).
AS : Weak GDP, = poor bond prices, Strong GDP strong bonds. GDP and Bond prices positively correlated.
Leave AS fixed. And imagine economy near capacity.
AD increases (curve move right and upwards). GDP grows, upward pressure on prices, interest rates higher. Bond prices weaker
AS declines (curve move left and down) GDP weak, limited pressure on prices. Interest rates move likely to come down. Bond prices do well.
AD : Strong GDP, Weaker bond prices, Weaker GDP stronger bond prices GDP and Bond prices negatively correlated.
Thank you Mickey, I’m clear on supply/demand dynamics. The point I don’t quite get is this:
‘AS increases the supply curve moves down to the right. GDP expands and prices fall. inflation low’
Thats clear - makes perfect sense to me.
That presumably leads to low term premium. i.e. return inversely proportional to GDP - am I right?.
But the reading says: “When growth and inflation are primarily driven by aggregate supply, nominal bond returns tend to be positively correlated with growth, necessitating a higher term premium.”
There logic is.
Investments assets will have a value if they protect you bad economic outcomes.
Simply
The economy is bad. But my investments do well. Investments that can do this would be in demand and the returns lower generally. They have a lower term premium because of their ability to hedge in poor economic conditions.
Assets who returns are correlated with economic conditions have a high term premium. Bad economic times also means bad investment returns. People demand a higher premium (level of return) from these types of assets.
Economy driven by AD. Bond returns and economy negatively correlated = low term premium
Economy driven by AS: Bond returns and economy positive correlated = high term premium.
Away from bonds to get the idea.
I am an equity fund manager. My firm does well is share price go higher (AUM rises = bigger fees). I invest my own money. If I buy equity shares with my savings by wages and investments are positively correlated. My savings would not offer a hedge against wages declining. When considering an equity investment I should be looking for high returns to compensate for the high correlation.
If I could fund an asset that was negatively correlated to by wages I should be willing to accept a lower average return as there is a benefit from correlation.