Financial Markets and Forecasting Interest Rates - Essay Example

? Introduction to Financial Markets - Forecasting interest rates Introduction to Financial Markets - Forecasting interest rates The "credit markets" section in a recent issue of The Financial Times Credit markets: Paper weight By Aline van Duyn, Michael Mackenzie and Richard Milne Topic: Some buyers fear a bond bubble may be building In this article, a Gary Lieb, a broker at Manhattan’s Apple Mortgage wonders why and how there are such cheap borrowing rates on mortgage loans. The worst thing, he says is that he cannot benefit from them to lower his monthly payments. Several years have passed after home price fell, his Long Island asset loan is too big relative to the value of the house. In this sense, the condition that Mr. Lieb is experiencing is a small-scale illustration of the forces placing much pressure on the financial markets and the economy. Interest rates, according to the Financial Times , have fallen back to the historic lows, permitting companies, individuals, and some countries to borrow loans at a price lower than before. Contrary to this, households and the extensive economy still fight back in the wake of credit stagnation. The relationship between these two forces, that is the stimulating impact on economic operations of low borrowing prices and the damping impact of a liability squeeze has adverse repercussions for investors globally, from those individuals who save on their own to the world’s largest insurance companies (Aline, Mackenzie, & Milne, 2010). For the past couple of years, following the 2008 collapse in equity markets as well as in a hysterical serach for “secure” investments, more cash has been poured into bonds as compared to earlier times. Bonds from the U.S Treasury debt to upcoming market corporate bonds have been performing amazingly well, being ranked among the possessions around the world that have generated the largest returns in 2009 and 2010. On the other hand, if the descending trend in rates were to come to an end, then there may be an abrupt halt to the rally in bonds. In the same way that falling interest rates raise the bond prices paying flat rates of interest, increasing rates eat into their value and push costs lower. It is noted that when the interest rates rises, bond holders and bonds funds are likely to undergo losses. In fact, in the near future, it is expected that borrowing rates may fall even lower. At the time when the article was written, the Federal Reserve was planning to buy government bonds with the only aim of pushing interest rates lesser (Aline, Mackenzie, & Milne, 2010). The issue to focus on in this section is that, even after extra two years of close to zero official rates and large quantities of stimulus spending, big economies like the United States have not grown as strongly as they expected. This is the reason why the Fed is planning to start its “quantitative easing” despite the fact that there are many investors and economists who doubt that it will have a powerful impact on economic growth. The Fed is making interest rates low, which means inflation and decreased bond yield, seeming like a bubble. The factors likely to have an impact on future interest rate movements An interest rate can be defined as the quantity of money received in connection to a loan, generally stated as a ratio of dollars obtained for each hundred dollars lent. From the credit markets review in the section above, there are factors that may affect future interest rate movements.  First, the U.S economy is an important player in this section. When it grows, consumers get employment and thus get some investments to lend through banks, though they must also borrow to purchase big items like cars or homes, or to fund other properties by using credit cards. For instance, Lieb, in the article claims that he has never experienced such inexpensive borrowing rates on housing loans. This means that when the funds’ demands drop, interest falls. In contrast, when funds’ demand increases, there is a rise in interest rates, acting as a ration for the available funds. It is evident from the article that the government bonds’ value is determined by inflation and interest rate expectations, yet investors still anticipate to get back the total amount they invested. With this in mind, it can be observed that inflationary pressures will most likely have an impact on future interest rates movements. This is because the paid rates on most loans are often fixed in the loan agreement. According to Cox, Ingersoll & Ross, 1985, a lender may not wish to lend out money for any given period of time if the power of purchasing that money will most likely be less at the time of repayment. This will therefore force the lender to demand a higher rate called inflationary premium. The idea behind this scenario is that, inflation increases interest rates, while deflation makes them to decline. The most important force to be watched when determining the factors that determine future moves of interest rates is the Federal Reserve. This unit known as the Fed is in control of credit available to be lend as well as the interest rates levels at which the funds are availed. Its significance in the financial operations system is further than the scope of the above factors. The market as represented in the above section of the Financial Times against my assessment of the factors that may influence interest rates According to the article, quantitative easing raises bond prices to initiate the fantasy of high yearly market returns, but eventually it arrives at a dead end, where those prices are stuck and cannot move upward any longer. This yield-chasing leads to thoughts that emerging market bond and junk bonds are too superior. For instance, low bond yields make insurance companies and pension funds to yearn for yields. This stimulates the risk that such institutional investors may move to corporate bonds to seek for yields. This is contrary to my view that international forces have a big influence on the interest rates.  It is even logical to argue that though it looks like some situations force investors to seek for yields, they are often willing to lend money to the government. They supplement local sources of finances in the market, driving interest rates lower. If they were to make decisions to sell or reduce their holdings in the U.S and make their investments elsewhere, extra funds would be generated from local sources, would make interest rates to increase with time, thus a stable market (Kuttner, 2001). A forecast on interest rates on the basis of factors that affect interest rates over the next 6 months In this forecast, it is vital to consider that six months is a short period of time in interest rates context.  While long-term interest rates are driven by the market, short-term interest rates are broadly Federal Reserve-driven. Within a scope of six months, short term interest rates may still be low, at nearly the present level of fifteen hundredths of a single percent. The Fed may begin to worry about inflation, then it will probably stop purchasing long-term securities, but later on raise short-term rates. The best estimate however is that the real performance may be more than five percent points less than where the economy should be, given that it is not growing very fast ( Yelena & Takhtamanova, 2012). It is probable that due to the persistent and large underperformance of the current economy, the Fed would not tighten up in the coming six months. I expect a gradual and little boost in long-term interest rates in the next 6 months. However, the interest rates could rise a bit faster above 3% in one year‘s time, maybe at 3.5%. This little gain may push up mortgage rates to at least 5.5%, which in my opinion, is still a low rate. There is a possibility that the increase from three to five percent will discourage individuals with low-priced mortgages from moving. My observations and critical reflections A look at the article from the Financial Times and the above arguments on the factors reveals that connections among interest rates in various markets have passed through different changes in recent times. All these changes seem to have been caused by inflation, but the new pattern is likely due to a reflection of diverse alterations in the policy environment. This may be inclusive of the elimination of exchange controls and related restraints on global capital movements in individual nations, through local deregulation and the growth of the financial markets internationally. I can conclude that in general measures, interest rates may be dependent on how intimately financial markets are integrated, in financial assets, and different interest rate expectations by individuals or lending institutions. International forces, basically regarding investors have their own expectations but it is not a wonder to find yields in different countries moving at a close pace. Interest rate movements expectations therefore  may not only base on expected inflation diversities, but also on changes in the rate patterns that market participants think will occur. The intention may be to correct earlier deviations from the parity of purchasing power or to restore more balance in exterior existing-account positions.     References Aline van Duyn, Mackenzie, M and Milne, R, 2010, Credit markets: Paper weight “Some buyers fear a bond bubble may be building” The Financial Times. Cox, J. C., Ingersoll Jr, J. E., & Ross, S. A, 1985, A theory of the term structure of interest rates. Econometrica: Journal of the Econometric Society, 385-407. Kuttner, K. N, 2001, Monetary policy surprises and interest rates: Evidence from the Fed funds futures market. Journal of monetary economics, 47(3), 523-544. Shiller, R. J., Campbell, J. Y., Schoenholtz, K. L., & Weiss, L. (1983). Forward rates and future policy: Interpreting the term structure of interest rates. Brookings Papers on Economic Activity, 1983(1), 173-223.  Yelena, F., & Takhtamanova, E, 2012, The economic outlook and monetary policy. Read More