In recent months there has been growing uncertainty across the global economy as to whether the US economy was going to experience a ‘hard’ or ‘soft landing’ in the current business cycle – the repeated sequences of expansion and contraction in economic activity over time. Announcements of macroeconomic indicators have been keenly anticipated for signals about how quickly the US economy is slowing.
Such heightened uncertainty is a common feature of late-cycle slowing economies, but uncertainty now has been exacerbated because it has been a while since developed economies have experienced a business cycle like the current one. The 21st century has been characterised by low inflation, low interest rates and recessions caused by various types of crises – a stock market crisis (2001), a banking crisis (2008) and a global pandemic (2020). In contrast, the current cycle is a throwback to the 20th century. The high inflation and the ensuing increases in interest rates have produced a business cycle which echoes the 1970s. Therefore, few investors have experience of such economic conditions.
The focus for investors during this stage of the cycle is when the slowing economy will reach the minimum. They will also be concerned with the depth of the slowdown: will there still be some growth in income, albeit low; or will the trough be severe enough to produce a recession, and, if so, how deep? Given uncertainty around the length and magnitude of business cycles, this leads to greater risk aversion among investors. This affects reactions to announcements of leading and lagging macroeconomic indicators.
This blog examines what sort of economic conditions we should expect in a late-cycle economy. It analyses the impact this has had on investor behaviour and the ensuing dynamics observed in financial markets in the USA.
The Business Cycle
The business cycle refers to repeated sequences of expansion and contraction (or slowdown) in economic activity over time. Figure 1 illustrates a typical cycle. Typically, these sequences include four main stages. In each one there are different effects on consumer and business confidence:
- Expansion: During this stage, the economy experiences growth in GDP, with incomes and consumption spending rising. Business and consumer confidence are high. Unemployment is falling.
- Peak: This is the point at which the economy reaches its maximum output, but growth has ceased (or slowed). At this stage, inflationary pressures peak as the economy presses against potential output. This tends to result in tighter monetary policy (higher interest rates).
- Slowdown: The higher interest rates raise the cost of borrowing and reduce consumption and investment spending. Consumption and incomes both slow or fall. (Figure 1 illustrates the severe case of falling GDP (negative growth) in this stage.) Unemployment starts rising.
- Trough: This is the lowest point of the cycle, where economic activity bottoms out and the economy begins to recover. This can be associated with slow but still rising national income (a soft landing) or national income that has fallen (a hard landing, as shown in Figure 1).
While business cycles are common enough to enable such characterisation of their temporal pattern, their length and magnitude are variable and this produces great uncertainty, particularly when cycles approach peaks and troughs.
As an economy’s cycle approaches a trough, such as US economy’s over the past few months, uncertainty is exacerbated. The high interest rates used to tackle inflation will have increased borrowing costs for businesses and consumers. Access to credit may have become more restricted. Profit margins are reduced, especially for industrial sectors sensitive to the business cycle, reducing expected cash flows.
The combination of these factors can increase the risk of a recession, producing greater volatility in financial markets. This manifests itself in increased risk aversion among investors.
Utility theory suggests that, in general, investors will exhibit loss aversion. This means that they do not like bearing risk, fearing that the return from an investment may be less than expected. In such circumstances, investors need to be compensated for bearing risk. This is normally expressed in terms of expected financial return. To bear more risk, investors require higher levels of return as compensation.
As perceptions of risk change through the business cycle, so this will change the return investors will require from the financial instruments they hold. Perceived higher risk raises the return investors will require as compensation. Conversely, lower perceived risk decreases the return investors expect as compensation.
Investors’ expected rate of return is manifested in the discount rate that they use to value the anticipated cash flows from financial instruments in discounted cash flow (DCF) analysis. Equation 1 is the algebraic expression of the present-value discounted series of cash flows for financial instruments:
Where:
V = present value
C = anticipated cash flows in each of time periods 1, 2, 3, etc.
r = expected rate of return
For fixed-income debt securities, the cash flow is constant, while for equity securities (shares), expectations regarding cash flows can change.
Slowing economies and risk aversion
In a slowing economy, with great uncertainty about the scale and timing of the bottom of the cycle, investors become more risk averse about the prospects of firms. This this leads to higher risk premia for financial instruments sensitive to a slowdown in economic activity.
This translates into a higher expected return and higher discount rate used in the valuation of these instruments (r in equation 1). This produces decreases in perceived value, decreased demand and decreased prices for these financial instruments. This can be observed in the market dynamics for these instruments.
First, there may be a ‘flight to safety’. Investors attach a higher risk premium to risker financial instruments, such as equities, and seek a ‘safe-haven’ for their wealth. Therefore, we should observe a reorientation from more risky to less risky assets. Demand for equities falls, while demand for safer assets, such as government bonds and gold, rises.
There is some evidence for this behaviour as uncertainty about the US economic outlook has increased. Gold, long seen as a hedge against market decline, is at record highs. US Government bond prices have risen too.
To analyse whether this may be a flight to safety, I analysed the correlation between the daily US government bond price (5-year Treasury Bill) and share prices represented by the two more significant stock market indices in the USA: the S&P 500 and the Nasdaq Composite. I did this for two different time periods. Table 1 shows the results. Panel (a) shows the correlation coefficients for the period between 1 May 2024 and 31 July 2024; Panel (b) shows the correlation coefficients for the period between 1 August 2024 and 9 September 2024.
In the period between May and July 2024, the 5-year Treasury Bill and share price indices had significantly positive correlations. When share prices rose, the Treasury Bill’s price rose; when share prices fell, the bill’s price fell. During that period, expectations about falling interest rates dominated valuations and that effected the valuations of all financial instruments in the same way – lower expected interest rates reduce the opportunity cost of holding instruments and reduces the expected rates of return. Hence, the discount rate applied to cash flows is reduced, and present value rises. The opposite happens when macroeconomic indicators suggest that interest rates will stay high (ceteris paribus).
As the summer proceeded, worries about a ‘hard landing’ began to concern investors. A weak jobs report in early August particularly exercised markets, producing a ‘flight to safety’. Greater risk aversion among investors meant that they expect a higher return from equities. This reduced perceived value, reducing demand and price (ceteris paribus). To insulate themselves from higher risk, investors bought safer assets, like government bonds, thereby pushing up their prices. This behaviour was consistent with the significant negative correlation observed between US government debt prices and the S&P 500 and Nasdaq indices in Panel (b).
Another signal of increased risk aversion among investors is ‘sector rotation’ in their equity portfolios. Increased risk aversion among investors will lead them to divest from ‘cyclical’ companies. Such companies are in industrial sectors which are more sensitive to the changing economic conditions across the business cycle – consumer discretionary and communication services sectors, for example. To reduce their exposure to risk, investors will switch to ‘defensive’ sectors – those less sensitive to the business cycle. Examples include consumer staples and utility sectors.
Cyclical sectors will suffer a greater adverse impact on their cash flows and risk in a slowing economy. Consequently, investors expect higher return as compensation. This reduces the value of those shares. Demand for them falls, depressing their price. In contrast, defensive sectors will be valued more. They will see an increase in demand and price. This sector rotation seems to have happened in August (2024). Figure 2 shows the percentage change between 1 August and 9 September 2024 in the S&P 500 index and four sector indices, comprising companies from the communication services, consumer discretionary, consumer staples and utilities sectors.
Overall, the S&P 500 index was slightly higher, as shown by the first bar in the chart. However, while the cyclical sectors experienced decreases in their share prices, particularly communication services, the defensive companies experienced large price increases – nearly 3% for utilities and over 6% for consumer staples.
Conclusion
Economies experience repeated sequences of expansion and contraction in economic activity over time. At the moment, the US economy is approaching the end of its current slowing phase. Increased uncertainty is a common feature of late-cycle economies and this manifests itself in heightened risk aversion among investors. This produces certain dynamics which have been observable in US debt and equity markets. This includes a ‘flight to safety’, with investors divesting risky financial instruments in favour of safer ones, such as US government debt securities and gold. Also, investors have been reorientating their equity portfolios away from cyclicals and towards defensive securities.
Articles
- America’s recession signals are flashing red. Don’t believe them
The Economist (22/8/24)
- The most well-known recession indicator stopped flashing red, but now another one is going off
CNN, Elisabeth Buchwald (13/9/24)
- World’s largest economy will still achieve soft landing despite rising unemployment, most analysts believe
Financial Times, Claire Jones, Delphine Strauss and Martha Muir (6/8/24)
- We’re officially on slowdown watch
Financial Times, Robert Armstrong and Aiden Reiter (30/8/24)
- Anatomy of a rout
Financial Times, Robert Armstrong and Aiden Reiter (6/8/24)
- Reasons why investors need to prepare for a US recession
Financial Times, Peter Berezin (5/9/24)
- Business Cycle: What It Is, How to Measure It, and Its 4 Phases
Investopedia, Lakshman Achuthan (6/6/24)
- Risk Averse: What It Means, Investment Choices, and Strategies
Investopedia, James Chen (5/8/24)
Data
Questions
- What is risk aversion? Sketch an indifference curve for a risk-averse investor, treating expected return and risk as two-characteristics of a financial instrument.
- Show what happens to the slope of the indifference curve if the investor becomes more risk averse.
- Using demand and supply analysis, illustrate and explain the impact of a flight to safety on the market for (i) company shares and (ii) US government Treasury Bills.
- Use economic theory to explain why the consumer discretionary sector may be more sensitive than the consumer staples sector to varying incomes across the economic cycle.
- Research the point of the economic cycle that the US economy has reached as you read this blog. What is the relationship between bond and equity prices? Which sectors have performed best in the stock market?
A common practice of international investors is to take part in the so-called ‘carry trade’. This involves taking advantage of nominal interest rate differences between countries. For example, assume that interest rates are low in Japan and high in the USA. It is thus profitable to borrow yen in Japan at the low interest rate, exchange it into US dollars and deposit the money at the higher interest rate available in the USA. If there is no change in the exchange rate between the dollar and the yen, the investor makes a profit equal to the difference in the interest rates.
Rather than depositing the money in a US bank account, an alternative is to purchase US bonds or other assets in the USA, where the return is again higher than that in Japan.
If, however, interest-rate differentials narrow, there is the possibility of the carry trade ‘unwinding’. Not only may the carry trade prove unprofitable (or less so), but investors may withdraw their deposits and pay back the loans. This, as we shall, can have adverse consequences on exchange rates.
The problem of an unwinding of the carry trade is not new. It worsened the underlying problems of the financial crisis in 2008. The question today is whether history is about to repeat itself with a new round of unwinding of the carry trade threatening economic growth and recovery around the world.
We start by looking at what happened in 2008.
The carry trade and the 2008 financial crisis
Prior to the financial crisis of 2008, current account deficit countries, such as the UK, USA and Australia, typically had relatively high interest rates, while current account surplus countries such as Japan and Switzerland had relatively low ones. Figure 1 shows central bank interest rates from 2005 to the current day (click here for a PowerPoint).
The carry trade saw investors borrowing money in Japan and Switzerland, exchanging it on the foreign exchange market, with the currency then deposited in the UK, USA and Australia. Hundreds of billions worth of dollars were involved in this carry trade.
If, however, the higher interest rates in the UK and other deficit countries were simply to compensate investors for the risk of currency depreciation, then there would be no excessive inflow of finance. The benefit of the higher interest rate would be offset by a depreciating currency. But the carry trade had the effect of making deficit currencies appreciate, thereby further boosting the carry trade by speculation of further exchange rate rises.
Thus the currencies of deficit countries appreciated, making their goods less competitive and worsening their current account deficit. Between 1996 and 2006, the average current account deficits as a percentage of GDP for Australia, the USA and the UK were close to 4½, 4 and 2, respectively. Between January 1996 and December 2006, the broad-based real exchange rate index of the Australian dollar appreciated by 17%, of the US dollar by 4% and of sterling by some 23%.
Currencies of surplus countries depreciated, making their goods more competitive and further boosting their current account surpluses. For example, between 2004 and 2006 the average current account surpluses as a percentage of GDP for Japan and Switzerland were 3½ and 13, respectively. Their short-term interest rates averaged a mere 0.1% and 1.0% respectively (compared with 3.4%, 4.7% and 5.7% for the USA, the UK and Australia). Yet between January 2004 and December 2006, the real exchange rate index of the yen depreciated by 21%, while that of the Swiss franc depreciated by 6%.
With the credit crunch of 2007/8, the carry trade unwound. Much of the money deposited in the USA had been in highly risky assets, such as sub-prime mortgages. Investors scrambled to sell their assets in the USA, UK and the EU. Loans from Japan and Switzerland were repaid and these countries, seen as ‘safe havens’, attracted deposits. The currencies of deficit countries, such as the UK and USA, began to depreciate and those of surplus countries, such as Japan and Switzerland, began to appreciate. Between September 2007 and September 2008, the real exchange rate indices of the US dollar and sterling depreciated by 2% and 13% respectively; the yen and the Swiss franc appreciated by 3% and 2¾%.
This represented a ‘double whammy’ for Japanese exporters. Not only did its currency appreciate, making its exports more expensive in dollars, euros, pounds, etc., but the global recession saw consumers around the world buying less. As a result, the Japanese economy suffered the worst recession of the G7 economies.
The carry trade in recent months
Since 2016, there has been a re-emergence of the carry trade as the Fed began raising interest rates while the Bank of Japan kept rates at the ultra low level of –0.1% (see Figure 1). The process slowed down when the USA lowered interest rates in 2020 in response to the pandemic and fears of recession. But when the USA, the EU and the UK began raising rates at the beginning of 2022 in response to global inflationary pressures, while Japan kept its main rate at –0.1%, so the carry trade resumed in earnest. Cross-border loans originating in Japan (not all of it from the carry trade) had risen to ¥157tn ($1tn) by March 2024 – a rise of 21% from 2021.
The process boosted US stock markets and contributed to the dollar appreciating against the yen (see Figure 2: click here for a PowerPoint).
Although this depreciation of the yen helped Japanese exports, it also led to rising prices. Japanese inflation rose steadily throughout 2022. In the 12 months to January 2022 the inflation rate was 0.5% (having been negative from October 2020 to August 2021). By January 2023, the annual rate had risen to 4.3% – a rate not seen since 1981. The Bank of Japan was cautious about raising interest rates to suppress this inflation, however, for fear of damaging growth and causing the exchange rate to appreciate and thereby damaging exports. Indeed, quarterly economic growth fell from 1.3% in 2023 Q1 to –1.0% in 2023 Q3.
But then, with growth rebounding and the yen depreciating further, in March 2024 the Bank of Japan decided to raise its key rate from –0.1% to 0.1%. This initially had the effect of stabilising the exchange rate. But then with the yen depreciating further and inflation rising from 2.5% to 2.8% in May and staying at this level in June, the Bank of Japan increased the key rate again at the end of July – this time to 0.25% – and there were expectations that there would be another rise before the end of the year.
At the same time, there were expectations that the Fed would soon lower its main rate (the Federal Funds Rate) from its level of 5.33%. The ECB and the Bank of England had already begun lowering their main rates in response to lower inflation. The carry trade rapidly unwound. Investors sold US, EU and UK assets and began repaying yen loans.
The result was a rapid appreciation of the yen as Figure 3 shows (click here for a PowerPoint). Between 31 July (the date the Bank of Japan raised interest rates the second time) and 5 August, the dollar depreciated against the yen from ¥150.4 to ¥142.7. In other words, the value of 100 yen appreciated from $0.66 to $0.70 – an appreciation of the yen of 6.1%.
Fears about the unwinding of the carry trade led to falls in stock markets around the world. Not only were investors selling shares to pay back the loans, but fears of the continuing process put further downward pressure on shares. From 31 July to 5 August, the US S&P 500 fell by 6.1% and the tech-heavy Nasdaq by 8.0%.
As far as the Tokyo stock market was concerned, the appreciation of the yen sparked fears that the large Japanese export sector would be damaged. Investors rushed to sell shares. Between 31 July and 5 August, the Nikkei 225 (the main Japanese stock market index) fell by 19.5% – its biggest short-term fall ever (see Figure 4: click here for a PowerPoint).
Although the yen has since depreciated slightly (a rise in the yen/dollar rate) and stock markets have recovered somewhat, expectations of many investors are that the unwinding of the yen carry trade has some way to go. This could result in a further appreciation of the yen from current levels of around ¥100 = $0.67 to around $0.86 in a couple of years’ time.
There are also fears about the carry trade in the Chinese currency, the yuan. Some $500 billion of foreign currency holdings have been acquired with yuan since 2022. As with the Japanese carry trade, this has been encouraged by low Chinese interest rates and a depreciating yuan. Not only are Chinese companies investing abroad, but foreign companies operating in China have been using their yuan earnings from their Chinese operations to invest abroad rather than in China. The Chinese carry trade, however, has been restricted by the limited convertibility of the yuan. If the Chinese carry trade begins to unwind when the Chinese economy begins to recover and interest rates begin to rise, the effect will probably be more limited than with the yen.
Articles
- A popular trading strategy just blew up in investors’ faces
CNN, Allison Morrow (7/8/24)
- The big ‘carry trade’ unwind is far from over, strategists warn
CNBC, Sam Meredith (13/8/24)
- Unwinding of yen ‘carry trade’ still threatens markets, say analysts
Financial Times, Leo Lewis and David Keohane (7/8/24)
- The yen carry trade sell-off marks a step change in the business cycle
Financial Times, John Plender (10/8/24)
- Forbes Money Markets Global Markets React To The Japanese Yen Carry Trade Unwind
Forbes, Frank Holmes (12/8/24)
- 7 unwinding carry trades that crashed the markets
Alt21 (26/1/23)
- A carry crash also kicked off the global financial crisis 17 years ago — here’s why it’s unlikely to get as bad this time
The Conversation, Charles Read (9/8/24)
- What is the Chinese yuan carry trade and how is it different from the yen’s?
Reuters, Winni Zhou and Summer Zhen (13/8/24)
- Carry Trade That Blew Up Markets Is Attracting Hedge Funds Again
Yahoo Finance/Bloomberg, David Finnerty and Ruth Carson (16/8/24)
- Currency Carry Trades 101
Investopedia, Kathy Lien (9/8/24)
- Carry Trades Torpedoed The Market. They’re Still Everywhere.
Finimize, Stéphane Renevier (13/8/24)
Questions
- What factors drive the currency carry trade?
- Is the carry trade a form of arbitrage?
- Find out and explain what has happened to the Japanese yen since this blog was written.
- Find out and explain some other examples of carry trades.
- Why are expectations so important in determining the extent and timing of the unwinding of carry trades?
Gold has always held an allure and with the price of gold on international markets trending upwards since October 2022 (see Figure 1: click here for a PowerPoint), people seem to be attracted to it once again. The price reached successively higher peaks throughout 2023 before surging to above $2300 per oz in 2024 and peaking at $2425.31 per oz on 20 May 2024.
While gold tends to become attractive during wartime, economic uncertainty and bouts of inflation, all of which have characterised the last few years, the sustained price rise has perplexed market analysts and economists. The rally had been expected to peter out over the past 20 months. But, as the price of gold rose to sustained higher levels, with no significant reversals, some analysts have speculated that it is not the typical short-term factors which are driving the increased demand for and price of gold but more fundamental changes in the global economic system.
This blog will first discuss the typical short-term factors which influence gold prices before discussing the potential longer-term forces that may be at work.
Short-term factors
So, what are the typical short-term economic forces which drive the demand for gold?
The most significant are the real rates of interest on financial assets. These rates represent the opportunity cost of holding an asset such as gold which offers no income stream. When the real return from financial assets like debt and equity instruments is low, the demand for and price of gold tends to be high. In contrast, when the real return from such assets is high, the price of gold tends to be lower. An explanation for this is that real rates of return are strongly related to inflation rates and investors perceive gold as a hedge against inflation since its price is positively correlated with a general rise in prices. Higher unexpected inflation reduces the real rate of return of securities like debt and equity whose value is derived from cash flows anticipated in the future. In such circumstances, gold become an attractive alternative investment. As inflationary expectations decline, real returns from financial assets should rise, and the demand for gold should fall.
The relationship between real returns, proxied by the yield on US 10-year TIPS (Treasury inflation-protected securities), and gold prices can be used to examine this explanation. Real returns rose steadily in the aftermath of the COVID-19 pandemic. Yet the price of gold, which rose during the early stages of the pandemic in 2020, has not fallen. Instead, it has remained at elevated levels for much of that time (see Figure 2: click here for a PowerPoint).
There have been short periods when changes in real returns seemed to have a high correlation with changes in gold prices. In late 2022, for example, falling real rates coincided with rising gold prices. The same pattern was repeated between October and December 2023. However, when real returns rose again in the New Year of 2024, in response to stubbornly higher expected inflation and the expectation of ‘higher-for-longer’ interest rates, particularly in the USA, gold prices continued to rise. Indeed, across the 5-year period the correlation coefficient between the two series is actually positive at 0.268, showing little evidence supporting this explanation for the pattern for the gold price.
Real returns in the USA, however, may not be the correct ones to consider when seeking explanations for the pattern of gold’s price. Much of the recent demand is from China. Analysts suggest that Chinese investors are looking for a safe asset to hold as their economy stagnates and real returns from alternatives, like domestic property and equity, have decreased. Further, there are some concerns that the Chinese currency, the renminbi, may be undervalued in response to the sluggish growth. Holding gold is a good hedge against inflation (currency depreciation produces inflationary pressure). Consequently, the Chinese market may be exerting pricing power in relation to real returns in a way not seen before (see the Dempsey and Leng FT article linked below).
However, some analysts suggest that the rise in price is disproportionate to these short-term factors and point to potential long-term structural changes in the global financial order which may produce significant changes in the market for gold.
Long-term factors
Since 2018, there have been bouts of gold purchasing by central banks around the world. In contrast to the 1990s and 2000s, central banks have been net purchasers since 2010. The purchasing fell back during the coronavirus pandemic but has surged again, with over 1000 metric tonnes purchased in both 2022 and 2023 (see Figure 3: click here for a PowerPoint).
Analysts have pointed to similarities between the recent pattern and central bank purchases of gold during the late 1960s and early 1970s (see The Conversation article linked below). Then, central banks sought to diversify themselves from dollar-denominated assets due to concerns about higher inflation in the USA and its impact on the value of the US dollar. Under the Bretton Woods fixed exchange rate system, central banks could redeem dollars for gold from the US Federal Reserve at a fixed rate. The pressure on the USA to redeem the gold led to the collapse of the Bretton Woods fixed exchange rate system.
While the current period of central bank purchases does not appear to be related to expected inflation, some commentators suggest it could signal a regime change in the global financial system as significant as the collapse of Bretton Woods. The rise of Chinese political power and the resurgence of US isolationist tendencies portend an increasingly multipolar geopolitical scene. Such concerns may cause central bankers to diversify away from dollar denominated assets to avoid being caught out by geopolitical tensions. Gold may be perceived as an asset through which investors can hedge that risk better.
Indeed, the rise in demand among Chinese investors may indicate a reluctance to hold US assets due to their risk of seizure during heightened geopolitical tensions between China and the USA. Chinese holdings of US financial assets as a percentage of GDP are back to the level they were when the country joined the World Trade Organisation (WTO) in 2001 (see the Rana Foroohar FT article linked below). Allied to this is an increasing tendency to repatriate gold bullion from centres such as London and New York.
Added to these worries about geopolitical risk are concerns about traditional safe-haven assets – government debt securities. US government budget deficits and debt levels continue to rise. Similar patterns are observed across many developed market economies (DMEs). Analysts are concerned such debts are reaching unsustainable levels (economist.com). The view is that at some point, perhaps soon, a tipping point will be reached where investors recognise this. They will demand higher rates of return on these government debt securities, pushing yields up and prices down (bond yields and prices have a negative relationship).
In expectation of this, investors may be wary of holding such government debt securities and move to hold gold as an alternative safe-haven asset to avoid potential capital losses. However, there has been no sign of this behaviour in bond prices and yields yet.
Finally, there are economists who argue that the increased demand for gold is caused by a different regime-change in the global economy. This is not one driven by geopolitics, but by changing inflationary expectations – from a low-inflation, low-interest-rate environment to a higher-inflation, higher-interest-rate environment.
Some of the anticipation relating to inflation is derived from the persistent fiscal stimulus, evidenced by the higher government debt levels described above, coupled with the long period of monetary stimulus (quantitative easing) in developed market economies during the 2010s.
Further, some economists highlight the substantial capital investment needed for the green transition and reindustrialisation. While the financing for this capital investment may absorb some of the excess money flowing around financial markets, the scale involved will create a great demand for resources, fuelling inflation and raising the cost of capital as borrowers compete for resources.
Finally, the demographic forces from an aging population will also cause inflationary pressures. Rising dependency ratios across many developed market economics will create shortages, particularly of labour. This persistent scarcity of labour will continually drive up wages and prices, fuelling inflation and the demand for gold.
Conclusion
The recent surge in the price of gold has led to great interest by investors, financial market analysts and economists. At first, there was a perception that the price increase was similar to recent history and driven by short-term decreases in the real rate of return from financial assets, which reduced the opportunity cost of holding gold.
However, as the upward trend in the price of gold has persisted and does not seem to be explained by changes in real interest rates, economists have considered other reasons that might signal longer-term significant changes in the global financial system. These relate to changing geopolitical risk derived from an increasingly multipolar environment, concerns about the sustainability of government debt levels and expectations of persistently higher inflation in the world economy.
Only time will tell whether these explanations prove correct. If inflationary pressures subside, particularly in the USA, and if real returns from financial assets rebound, a decrease in the demand for and price of gold will suggest that the previous rise was driven by short-term forces.
If prices don’t fall back, it will only fuel the debate that it is a sign of significant changes in the global financial order.
Articles
- Gold’s weird rally
Financial Times, Robert Armstrong & Ethan Wu (11/12/23)
- A debt crisis at the economy’s edge
Financial Times, Robert Armstrong (15/5/24)
- Good, not great, news on inflation
Financial Times, Robert Armstrong (16/5/24)
- Gold prices are ‘dramatically outperforming’: Macquarie
Investing.com, Senad Karaahmetovic (30/5/24)
- Gold is back — and it has a message for us
Financial Times, Rana Foroohar (15/4/24)
- Countries went on a gold-buying spree before coronavirus took hold – here’s why
The Conversation, Drew Woodhouse (21/5/20)
- Why Gold Keeps Hitting Record Highs
Investopedia, Colin Laidley (9/4/24)
- Why Is the Price of Gold Rising?
Forbes, Wayne Duggan (23/4/24)
- Why gold prices are hitting record highs
TRT World, Kazim Alam (3/4/24)
- Chinese speculators super-charge gold rally
Financial Times, Harry Dempsey and Cheng Leng (23/4/24)
- This gold rally is made in China
Financial Times, Opinion Lex (21/5/24)
Speech
Data
Questions
- Explain the relationship between real returns and inflation for financial securities like debt and equity.
- Why is gold perceived to be an effective hedge against inflation?
- Contrast the factors which influenced the demand for gold in the period which preceded the end of Bretton Woods with those influencing demand now?
- What has happened to the price of gold since this blog was published? Is there any evidence for the profound changes in the global economic order suggested or was it the short-term forces driving demand after all?
To finance budget deficits, governments have to borrow. They can borrow short-term by issuing Treasury bills, typically for 1, 3 or 6 months. These do not earn interest and hence are sold at a discount below the face value. The rate of discount depends on supply and demand and will reflect short-term market rates of interest. Alternatively, governments can borrow long-term by issuing bonds. In the UK, these government securities are known as ‘gilts’ or ‘gilt-edged securities’. In the USA they are known as ‘treasury bonds’, ‘T-bonds’ or simply ‘treasuries’. In the EU, countries separately issue bonds but the European Commission also issues bonds.
In the UK, gilts are issued by the Debt Management Office on behalf of the Treasury. Although there are index-linked gilts, the largest proportion of gilts are conventional gilts. These pay a fixed sum of money per annum per £100 of face value. This is known as the ‘coupon payment’ and the rate is set at the time of issue. The ‘coupon rate’ is the payment per annum as a percentage of the bond’s face value:
Payments are made six-monthly. Each issue also has a maturity date, at which point the bonds will be redeemed at face value. For example, a 4½% Treasury Gilt 2028 bond has a coupon rate of 4½% and thus pays £4.50 per annum (£2.25 every six months) for each £100 of face value. The issue will be redeemed in June 2028 at face value. The issue was made in June 2023 and thus represented a 5-year bond. Gilts are issued for varying lengths of time from 2 to 55 years. At present, there are 61 different conventional issues of bonds, with maturity dates varying from January 2024 to October 2073.
Bond prices
Bonds can be sold on the secondary market (i.e. the stock market) before maturity. The market price, however, is unlikely to be the coupon price (i.e. the face value). The lower the coupon rate relative to current interest rates, the less valuable the bond will be. For example, if interest rates rise, and hence new bonds pay a higher coupon rate, the market price of existing bonds paying a lower coupon rate must fall. Thus bond prices vary inversely with interest rates.
The market price also depends on how close the bonds are to maturity. The closer the maturity date, the closer the market price of the bond will be to the face value.
Bond yields: current yield
A bond’s yield is the percentage return that a person buying the bond receives. If a newly issued bond is bought at the coupon price, its yield is the coupon rate.
However, if an existing bond is bought on the secondary market (the stock market), the yield must reflect the coupon payments relative to the purchase price, not the coupon price. We can distinguish between the ‘current yield’ and the ‘yield to maturity’.
The current yield is the coupon payment as a percentage of the current market price of the bond:
Assume a bond were originally issued at 2% (its coupon rate) and thus pays £2 per annum. In the meantime, however, assume that interest rates have risen and new bonds now have a coupon rate of 4%, paying £4 per annum for each £100 invested. To persuade people to buy old bonds with a coupon rate of 2%, their market prices must fall below their face value (their coupon price). If their price halved, then they would pay £2 for every £50 of their market price and hence their current yield would be 4% (£2/£50 × 100).
Bond yields: yield to maturity (YTM)
But the current yield does not give the true yield – it is only an approximation. The true yield must take into account not just the market price but also the maturity value and the length of time to maturity (and the frequency of payments too, which we will ignore here). The closer a bond is to its maturity date, the higher/lower will be the true yield if the price is below/above the coupon price: in other words, the closer will the market price be to the coupon price for any given market rate of interest.
A more accurate measure of a bond’s yield is thus the ‘yield to maturity’ (YTM). This is the interest rate which makes the present value of all a bond’s future cash flows equal to its current price. These cash flows include all coupon payments and the payment of the face value on maturity. But future cash flows must be discounted to take into account the fact that money received in the future is worth less than money received now, since money received now could then earn interest.
The yield to maturity is the internal rate of return (IRR) of the bond. This is the discount rate which makes the present value (PV) of all the bond’s future cash flows (including the maturity payment of the coupon price) equal to its current market price. For simplicity, we assume that coupon payments are made annually. The formula is the one where the bond’s current market price is given by:
Where: t is the year; n is the number of years to maturity; YTM is the yield to maturity.
Thus if a bond paid £5 each year and had a maturity value of £100 and if current interest rates were higher than 5%, giving a yield to maturity of 8%, then the bond price would be:
In other words, with a coupon rate of 5% and a higher YTM of 8%, the bond with a face value of £100 and five years to maturity would be worth only £88.02 today.
If you know the market price of a given bond, you can work out its YTM by substituting in the above formula. The following table gives examples.
The higher the YTM, the lower the market price of a bond. Since the YTM reflects in part current rates of interest, so the higher the rate of interest, the lower the market price of any given bond. Thus bond yields vary directly with interest rates and bond prices vary inversely. You can see this clearly from the table. You can also see that market bond prices converge on the face value as the maturity date approaches.
Recent activity in bond markets
Investing in government bonds is regarded as very safe. Coupon payments are guaranteed, as is repayment of the face value on the maturity date. For this reason, many pension funds hold a lot of government bonds issued by financially trustworthy governments. But in recent months, bond prices in the secondary market have fallen substantially as interest rates have risen. For those holding existing bonds, this means that their value has fallen. For governments wishing to borrow by issuing new bonds, the cost has risen as they have to offer a higher coupon rate to attract buyers. This make it more expensive to finance government debt.
The chart shows the yield on 10-year government bonds. It is calculated using the ‘par value’ approach. This gives the coupon rate that would have to be paid for the market price of a bond to equal its face value. Clearly, as interest rates rise, a bond would have to pay a higher coupon rate for this to happen. (This, of course, is only hypothetical to give an estimate of market rates, as coupon rates are fixed at the time of a bond’s issue.)
Par values reflect both yield to maturity and also expectations of future interest rates. The higher people expect future interest rates to be, the higher must par values be to reflect this.
In the years following the financial crisis of 2007–8 and the subsequent recession, and again during the COVID pandemic, central banks cut interest rates and supported this by quantitative easing. This involved central banks buying existing bonds on the secondary market and paying for them with newly created (electronic) money. This drove up bond prices and drove down yields (as the chart shows). This helped support the policy of low interest rates. This was a boon to governments, which were able to borrow cheaply.
This has all changed. With quantitative tightening replacing quantitative easing, central banks have been engaging in asset sales, thereby driving down bond prices and driving up yields. Again, this can be seen in the chart. This has helped to support a policy of higher interest rates.
Problems of higher bond yields/lower bond prices
Although lower bond prices and higher yields have supported a tighter monetary policy, which has been used to fight inflation, this has created problems.
First, it has increased the cost of financing government debt. In 2007/8, UK public-sector net debt was £567bn (35.6% of GDP). The Office for Budget Responsibility forecasts that it will be £2702bn (103.1% of GDP in the current financial year – 2023/24). Not only, therefore, are coupon rates higher for new government borrowing, but the level of borrowing is now a much higher proportion of GDP. In 2020/21, central government debt interest payments were 1.2% of GDP; by 2022/23, they were 4.4% (excluding interest on gilts held in the Bank of England, under the Asset Purchase Facility (quantitative easing)).
In the USA, there have been similar increases in government debt and debt interest payments. Debt has increased from $9tn in 2007 to $33.6tn today. Again, with higher interest rates, debt interest as a percentage of GDP has risen: from 1.5% of GDP in 2021 to a forecast 2.5% in 2023 and 3% in 2024. What is more, 31 per cent of US government bonds will mature next year and will need refinancing – at higher coupon rates.
There is a similar picture in other developed countries. Clearly, higher interest payments leave less government revenue for other purposes, such as health and education.
Second, many pension funds, banks and other investment companies hold large quantities of bonds. As their price falls, so this reduces the value of these companies’ assets and makes it harder to finance new purchases, or payments or loans to customers. However, the fact that new bonds pay higher interest rates means that when existing bond holdings mature, the money can be reinvested at higher rates.
Third, bonds are often used by companies as collateral against which to borrow and invest in new capital. As bond prices fall, this can hamper companies’ ability to invest, which will lead to lower economic growth.
Fourth, higher bond yields divert demand away from equities (shares). With equity markets falling back or at best ceasing to rise, this erodes the value of savings in equities and may make it harder for firms to finance investment through new issues.
At the core of all these problems is inflation and budget deficits. Central banks have responded by raising interest rates. This drives up bond yields and drives down bond prices. But bond prices and yields depend not just on current interest rates, but also on expectations about future interest rates. Expectations currently are that budget deficits will be slow to fall as governments seek to support their economies post-COVID. Also expectations are that inflation, even though it is falling, is not falling as fast as originally expected – a problem that could be exacerbated if global tensions increase as a result of the ongoing war in Ukraine, the Israel/Gaza war and possible increased tensions with China concerning disputes in the China Sea and over Taiwan. Greater risks drive up bond yields as investors demand a higher interest premium.
Articles
Information and data
Questions
- Why do bond prices and bond yields vary inversely?
- How are bond yields and prices affected by expectations?
- Why are ‘current yield’ and ‘yield to maturity’ different?
- What is likely to happen to bond prices and yields in the coming months? Explain your reasoning.
- What constraints do bond markets place on fiscal policy?
- Would it be desirable for central banks to pause their policy of quantitative tightening?
UK house prices have been falling in recent months. According to the Nationwide Building Society, average UK house prices in September 2023 were 5.3% lower than in September 2022. This fall reflects the increasing cost of owning a home as mortgage rates have risen. The average standard variable rate mortgage was 3.61% in August 2021, 4.88% in August 2022 and 7.85% in August 2023. A two-year fixed rate mortgage with a 10% deposit had an interest rate of 2.48% in August 2021, 3.93% in August 2022 and 6.59% in August 2023. Thus over two years, mortgage rates have more than doubled. This has made house purchase less affordable and has dampened demand.
But do house prices simply reflect current affordability? Given the large increase in mortgage costs and the cost-of-living crisis, it might seem surprising that house prices have fallen so little. After all, from September 2019 to August 2023, the average UK house price rose by 27.1% (from £215 352 to £273 751). Since then it has fallen by only 5.8% (to £257 808 in September 2023). However, there are various factors that help to explain why house prices have not fallen considerably more.
The first is that 74% of borrowers are on fixed-rate mortgages and 96% of new mortgages since 2019 have been at fixed rates. More than half of people with fixed rates have not yet had to renew their mortgage since interest rates began rising in December 2021. These people, therefore, have not yet been affected by the rise in mortgage interest rates.
The second is that interest rates are expected to peak and then fall. Even though by December 2024 another 2 million households will have had to renew their mortgage, those taking out new longer-term fixed rates may find that rates are lower than those on offer today. This could help to reduce the downward effect on house prices.
The third is that rents continue to rise, partly in response to the higher mortgage rates paid by landlords. With the price of this substitute product rising, this acts as an incentive for existing homeowners not to sell and existing renters to buy, even though they are facing higher mortgage payments.
The fourth is that house prices do not necessarily reflect the overall market equilibrium. People selling may hold out for a better price, hoping that they will eventually attract a buyer. Houses thus are taking longer to sell. This creates a glut of houses at above-equilibrium prices, with fewer sales taking place. At the same time, these higher prices depress demand. People would rather wait for a fall in house prices than pay the current asking price. This creates more of a ‘buyers’ market’, with some sellers being forced to sell well below the asking price. According to Zoopla (see linked article below), the average selling price is 4.2% below the asking price – the highest since 2019. Nevertheless, with sellers holding out and with reduced sales, actual sale prices have fallen less than if markets cleared.
So will house prices continue to fall and will the rate of decline accelerate? This depends on confidence and affordability. With interest rates falling, confidence and affordability are likely to rise. This will help to arrest further price falls.
However, with large numbers of people still on low fixed rates but with these fixed terms ending over the coming months, for them interest rates will be higher and this could continue to have a dampening effect on demand. What is more, affordability is likely to rise only slowly and in the short term could fall further. Petrol and diesel prices remain high and home energy costs and food prices are still well above the levels of two years ago. Inflation generally is coming down only slowly. The higher prices plus a rising tax burden from fiscal drag1 will continue to squeeze household budgets. This will reduce the size of deposits and the monthly payments that house purchasers can afford.
Over the longer term, house prices are set to rise again. Lower interest rates, rising real incomes again and a failure of house building to keep up with the growth in the number of people seeking to buy houses will all contribute to this. However, over the next few months, house prices are likely to continue falling. But just how much is difficult to predict. A lot will depend on expectations about house prices and incomes, how quickly inflation falls and how quickly the Bank of England reduces interest rates.
1 With tax thresholds frozen, as people’s wages rise, so a higher proportion of their income is taxed and, for higher earners, a higher proportion is taxed at a higher rate. This automatically increases income tax as a proportion of income.
Articles
- House Price Index – September 2023
Zoopla, Richard Donnell (28/9/23)
- UK home sellers increase discounts to secure deals, Zoopla data shows
Financial Times, Joshua Oliver (28/9/23)
- Buyer’s market! House hunters bag £12k off average asking price, says Zoopla
This is Money, Jane Denton (28/9/23)
- House price growth remained weak in September
Nationwide HPI Reports (2/10/23)
- UK mortgage approvals hit six-month low as interest rates cool market
The Guardian, Phillip Inman (29/9/23)
- UK house prices are plummeting at the most rapid pace in over a decade
Euronews, Daniel Harper (2/10/23)
- House prices fall across all UK regions for first time since 2009
Financial Times, Valentina Romei (2/10/23)
- Will house prices fall in 2023?
The Times, Hannah Smith and Georgie Frost (4/10/23)
- First-time buyers in UK drop by a fifth as higher mortgage costs bite
The Guardian, Julia Kollewe (27/9/23)
- England worst place in developed world to find housing, says report
The Guardian, Robert Booth (5/10/23)
- UK homeowners face huge rise in payments when fixed-rate mortgages expire
The Guardian, Richard Partington (17/6/23)
- UK house prices: Where the cheapest areas to buy are, and how far prices could fall
i News, Zesha Saleem (29/9/23)
- Why are house prices falling?
Independent, Vicky Shaw (7/9/23)
Data
Questions
- Use a supply and demand diagram to illustrate the situation where house prices are above the equilibrium.
- Why does house price inflation/deflation differ (a) from one type of house (or flat) to another; (b) from one region of the economy/locality to another?
- Find out why house prices rose so much (a) in the early 2000s; (b) from 2020 to 2022.
- Find out why house prices fell so much from 2008 to 2010. Why was this fall so much greater than in recent months?
- Find out what is happening to house prices in two other developed countries of your choice. How does the current housing market in these countries differ from that in the UK?
- Paint possible scenarios (a) where UK house prices continue to fall by several percentage points; (b) begin to rise again very soon.
