Chapter 5: Interest-Rate Fluctuations
The interest rate is not a fixed amount, though it can sometimes remain stable for long periods of time. It fluctuates according to the supply and demand of money in a given market: the more money is available to lend, the more power borrowers have to bid down the interest rate.
This brings to mind that the interest rate is not set by a central authority, but represents what a given source estimates to be the rate at which borrowers and lenders are making deals. Central banks have the ability to influence interest rates by altering the supply of money (making more or less available), but they do not have the ability to interfere with the private business of borrowers and lenders - merely to suggest and to influence.
Not only does the interest rate reflect the rates at which money is lent today, but it also impacts the value of existing contracts that pay more or less than the current interest rate (as discussed in the last chapter) on the premise that a person with money to lend may choose between funding a new loan or purchasing an existing one.
Back to the point: interest rates fluctuate in reaction to the behavior of lenders, borrowers, and the central bank - the rate may remain stable for a long time or be in constant fluctuation, and in the modern world of electronic information, the rate can change from one second to the next. And because markets are global, there is influence across markets that used to be separated because both borrowers and lenders may seek a better deal in a foreign market if they do not like what is on offer in their local area.
The notion that there is one interest rate at which borrowers and lenders are compelled to deal is a misunderstanding - as anyone who has applied for a loan knows, there is a market rate for various kinds of loan but that does not guarantee a given lender can borrow at that rate. In this sense, the rate is always a historical reference - it is the rate that was believed to be average as of the last time a deal was struck (and may not be the same for the very next deal).
Shifts in Supply and Demand for Bonds
Investment values fluctuate the same way that loans do - because a bond is essentially a company borrowing money from investors, who decide whether or not to take the deal. Those who supply bonds (borrowers) are willing to borrow money at a rate based on their ability to put the funds to profitable use, and those who demand bonds (lenders) are seeking to earn a certain level of return within a certain level of risk, comparing the bond to alternative vehicles for their investment.
In terms of demand, the wealth of a society determines the maximum level of demand for investments. This is entirely impractical, as it is not realistic to suggest a scenario in which every asset is liquidated or used as collateral to borrow its full value - but it does represent a factual extreme. In more practical terms, wealth is resident in physical items (cash, real estate, gold, gems, oil, or other items) and continues to exist until those physical items are consumed or destroyed. Trade does not destroy wealth, but merely transfers its possession from one person to another.
(EN: In more specific terms, economists refer to "wealth" as the assets that a person means to keep. Money in the bank is wealth, money carried to the store to purchase groceries is not wealth, and money invested in production is not wealth.)
Wealth can increase or decrease in value over time. Wealth invested in perishable objects is destroyed as the items rot. Wealth invested in durable objects (precious metal, gems, etc.) has an uncertain future because the value of those items may increase or decrease over time. And wealth that is held in the form of money diminishes over time as inflation erodes the value of money. These are the principle drivers of the demand for investments: unless the debtor defaults, the investor is contractually guaranteed that his wealth will increase in value (by earning interest).
With any investment, there is risk. The "default risk" or "credit risk" is the chance that the contract will not be honored and the investors funds (in whole or in part) will not be repaid. The "rate risk" is the chance that increasing interest rates will decrease the value of the investment and the holder who needs to liquidate it will be compelled to accept less than its face value.
For any investment, the investor considers the level of risk when determining what amount of return he will accept. Some investors wish to have higher returns and seek out investments with higher risks, whereas others are more conservative and will accept a lower return for a less risky investment. A given investor's tolerance for risk is entirely idiosyncratic and entirely psychological - economists acknowledge that risk aversion is a factor, but generally have no reliable way to estimate or predict it.
What all of this means to demand in the bond market is that there will be a certain amount of capital devoted by investors to purchase bonds of various levels of risk - just as there are certain amounts of money that shoppers are willing to spend on goods of a given level of quality. This desire, backed by a willingness to spend, is what constitutes the demand curve.
One the supply side of things, it is the aggregation of every business that wants to borrow money and is willing to pay a given rate to those who will lend it to them. The main driver of supply is the need to borrow capital - which means that businesses see opportunities to build and grow their operations in a given economy. This determines the amount of capital they will seek to borrow, and their prediction of the profit they can make on borrowed capital determines the amount of interest they can afford to pay.
Government budgets are also mentioned as a factor, as government is also a competitor in the bond industry (and generally offers the lowest rates because governments seldom go bankrupt and default on their loans). The rate paid on government bonds influences the rate that other issuers are able to charge because no buyer will accept a corporate bond that pays less than a government bond (whose return is also tax-free). So the minimum offer that a seller can make must account for the rate of government securities. So in all, we find that suppliers issue more bonds when the interest on government securities is low, taxes are low, and the economy is expanding.
And as in any market, the interest rate for bonds will go up when there are more companies that want to borrow money than there are investors who want to lend it (companies must increase returns to get investors) and down then there is more wealth seeking investment than bonds in which to invest it (investors being desperate, they are compelled to accept lower rates to get a bond).
(EN: Another factor the author missed is the returns that could be had in other investments. There is often a play between bonds, stocks, and other vehicles that influences the price of each.)
Liquidity Preference
Another factor that creates fluctuations in interest rate is the liquidity preference - the idea that most people prefer to have their wealth in a form that can be spent immediately. This is cash itself, which renders no interest. And so it follows that the longer the amount of time that the investor must wait to have his capital returned to him in liquid form, the higher the interest he will require. Hence the interest rate on a two-year loan will be less than that offered on a ten-year loan (all other things being equal).
He lurches back into supply and demand, and the basic principle that the more interest offered by borrowers, the more money people will be willing to invest in their debt. A person who may prefer the security of having ready cash will be willing to sacrifice liquidity as the interest rates offered to him increase. But again, this is psychological: how much interest is sufficient to make a person willing to undertake the risk and do without their money for a while is a matter of comfort and desire.
The Effect of the Money Supply
Another factor that is often overlooked is the demand for money. Since money is merely a token of exchange it is said to have no implicit value - it cannot be eaten or used for any practical purpose except to trade. But because it is useful in trade, there is a demand to have a certain amount of money. That is, people will want to have ready cash to pay their near-term expenses and they will not be willing to invest this money. A bond that pays good returns in ten years is not useful to pay the grocery bill this weekend.
So the amount of money available to invest is decreased by the amount of money people desire to have - it is only when they have more than they need to spend that they will consider investing. So a decrease in the money supply will increase interest rates because people are more fond of holding money than they are of having investments, and an increase in the money supply will lower interest rates because people have more money than need of money and seek a place to invest the excess.
Prior to fiat currency, the money supply could pose a problem. Consider that Europeans once traded in gold coins and specie until their fondness of imported goods drained the economy of its physical gold. There was a period of confusion as people had no money (literally) to pay for things - but this was alleviated when the country switched from the gold standard to the silver standard. That is, until the silver began disappearing into overseas coffers as well.
But in the modern day, most currencies are issued by fiat and when there is a shortage in the money supply government and central banks can simply put more money into the system. Unfortunately, this also causes inflation in prices (because more money means each unit of money is worth less in exchange) and increases interest rates. The system is constantly being tinkered with, which makes it impossible to find a natural point of equilibrium and, in some cases, causes economic disasters on a national and international scale.