1
$\begingroup$

I was wondering about why investors converting out of interest-bearing assets into money in the money market cause the interest rate to increase. Then I remembered that there is inverse relationship between prices of bonds and the interest rate. In case of bonds investors converting out of them would increase their supply, consequently lowering their prices. But lower prices of bonds mean higher de-facto interest rate for your investment into bonds because the quantity of money that you needed to make investment has decreased. Then it happened to me that the same logic can apply to interest-bearing assets in the general, not just to the bonds. And if it's correct it can serve as an explanation for exact mechanism of for increasing interest rate in the money market.

Am I correct about the relationship? Is there inverse relationship between interest-bearing assets and the interest rate? And if not, why?

$\endgroup$
  • $\begingroup$ My layman's common sense says: yes, and this is at least partly responsible for the rise in stock prices and house prices over the last while as people are increasingly encouraged to buy assets for their retirement savings. $\endgroup$ – user253751 Jul 2 at 12:02
  • 1
    $\begingroup$ “Interest” technically implies it is a fixed income security, which is a wider class of instruments than bonds. However, all fixed income securities have the same underlying pricing methodologies as bonds. I am unaware of any class of fixed income securities that does not obey the rule that there is an inverse relationship between the price and the interest rate/yield. So the answer to this question is just “Yes.” I think you need to be more careful in your wording if you want a longer answer. $\endgroup$ – Brian Romanchuk Jul 2 at 13:24
  • $\begingroup$ @BrianRomanchuk I'm satisfied with what you said. Please, convert your comment into answer so I could close this question $\endgroup$ – user161005 Jul 2 at 13:43
  • $\begingroup$ @BrianRomanchuk Just to be extra sure before we close this question, do I understand correctly that this relationship works in the both directions, that prices of bonds can change the real interest rate? I think it's the case, but only saw examples of interest rate changing prices of bonds, not vice versa. $\endgroup$ – user161005 Jul 2 at 13:50
  • 1
    $\begingroup$ Based on the comments, there’s a few definitions I need to cover. I’ll write out a longer answer that might help shortly. $\endgroup$ – Brian Romanchuk Jul 2 at 14:16
1
$\begingroup$

The shortest possible answer to the question in the title (as stated now): “Yes.”

However, based on the comments, there are questions about definitions. I will attempt to answer them.

A fixed income instrument is anything that pays the owner cashflows on a fixed legal schedule, and the owner is not obligated to make any payments (other than the initial payment). This covers bonds, loans, and other forms of debt.

If there is no optionality in the structure (not prepayable, etc.), the internal rate of return of the security is unique and has an inverse relationship with the initial price. (Excluding corner cases such as zero cost, etc.)

This internal rate of return is typically referred to as the rate of interest or yield of the instrument. (Bond and money markets have specific calculation conventions, which end up being a more complex version of the internal rate of return.)

When trading fixed income securities, they can be traded in terms of yield or price interchangeably (although markets follow conventions for which to use in a quote). As such, prices and “interest rates” are mechanically always moving inversely.

The question seems to be focussed more on the policy rate, which is often “the” interest rate in simplistic economic models. Modern central banks force a short-term nominal instrument rate (often overnight, but can be two weeks or even three months) to some target level, that is changed over time as a policy tool.

Despite what simplistic models say, there is no relationship between the “money supply” and this rate. (People discussing this relationship are typically using Economics 101 textbooks that are decades out of date.)

The yields on other instruments move around on a daily basis. Many factors can influence prices, but there are bedrock valuation principles.

  • Instruments that have no perceived default risk (e.g. most non-Euro area developed country sovereigns) have a fair value that matches the expected path of short-term rates. The set out of outstanding bonds defines a risk-free yield curve.
  • Other instruments will incorporate a default risk premium and/or a liquidity premium that is added to the risk-free yield curve.
| improve this answer | |
$\endgroup$
  • $\begingroup$ "Despite what simplistic models say, there is no relationship between the “money supply” and this rate." But I don't care about the money supply, instead I wonder if change in prices of interest-bearing assets change the nominal/real interest rate. I probably miss something, but I don't see how your answer answers this part $\endgroup$ – user161005 Jul 2 at 15:10
  • $\begingroup$ "Modern central banks force a short-term nominal instrument rate" In the money market model that I use the Central bank doesn't seem to target anything because the money supply curve is vertical. $\endgroup$ – user161005 Jul 2 at 15:39
  • $\begingroup$ The price/internal rate of return of a particular instrument (e.g. a bond) always move inversely - one defines the other. What “nominal interest rate” do you refer to? The policy rate is fixed by the central bank, and that does not change outside of policy meetings. $\endgroup$ – Brian Romanchuk Jul 2 at 15:55
  • $\begingroup$ "What “nominal interest rate” do you refer to?" The one which can change in response to higher/lower money demand in the money market, instead of central-planned approach of the central bank. I don't know proper name for this kind of interest rate, it's why I used description. $\endgroup$ – user161005 Jul 2 at 15:59
  • $\begingroup$ "The price/internal rate of return of a particular instrument (e.g. a bond) always move inversely - one defines the other. " In both directions? $\endgroup$ – user161005 Jul 2 at 16:02

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

Not the answer you're looking for? Browse other questions tagged or ask your own question.