Interest Rates, Bond Prices, and the Credit Cycle
This article was originally published as a sidebar to the Daniel Oliver interview entitled Signs the Credit Bubble Is Bursting (October 2018).
The inverse relation between bond or asset prices and the discount or interest rate isn’t self-evident to the uninitiated. Why do bond prices move opposite to interest rates?
WHAT’S THE DISCOUNT?
Think of it this way. What is a bond worth today that has a 5% interest rate and pays $100 in one year? (Interest rate is also called “discount rate,” i.e., the rate by which today’s price is ‘discounted’ from the future price.) It’s worth $100 today, less the future interest payment. So the value today (“net present value”) of that bond is $100 - $5 = $95.
What happens when you raise the discount rate? What about a bond with a 10% discount rate that pays $100 in one year? Today it is worth $100 - $10 = $90.
So it’s a see-saw. The higher the interest rate, the lower the bond price. When interest rates rise, bond prices fall. When interest rates fall, bond prices rise. It’s simply a mathematical relationship.
A “capital asset” is any asset that can produce a future stream of revenue (“cash flow”). For instance, a plant building washing machines is a “capital asset.” Its value is determined by discounting that future stream of revenue to the net present value. Think of bonds, too, as “capital assets,” because they produce a future stream of revenue; or stocks, paying future dividends.
Suppose the profit from a washing machine factory were $100 a year, and suppose the interest rate is 10%. The net present value of the factory is $90.
What happens if the interest rate falls to 5%? The net present value of the capital asset rises to $95. It doesn’t matter whether the interest rate is forced down by the abundance of bank credit, or because consumers are saving more so they can consume more in the future: the signal to factory builders is the same, namely, “Build more factories!”
CREDIT BOOM - OVERCAPACITY – OVERPRODUCTION - BUST
But if interest fell only because banks issued more credit, then consumers don’t really want to consume more in the future and factory builders received a false signal that consumers want more machines. When the future arrives, unsold washing machines back up on display floors, and capital asset owners discover that overcapacity in washing machine factories has caused overproduction. They lower their prices, a little at first, and then fear sends them tumbling and cascading. Even lowering prices won’t clear all the excess washing machines off the market, so producers go bankrupt. Enough producers must go bankrupt to eliminate all the overcapacity.
STOCKS & BONDS
Now think of all stocks and bonds as “capital assets.” Everything is priced according to its net present value, discounted by the economy’s base interest rate (plus a premium for risk, riskier assets paying a higher interest rate.) If interest rates fall, markets will re-price all capital assets higher because mathematically their net present value rises. Increasing bank credit lowers interest rates, which in turn raises asset prices. This is one reason the stock market rises when interest rates are lowered. The opposite is also true, that rising interest rates will lower asset prices.
Why? Because interest rates and prices are, mathematically, a see-saw. When rates rise, prices fall, and when rates fall, prices rise.
But of course, merely increasing bank credit can never increase asset prices permanently. Otherwise every Tom, Dick, and Harriet would be rich and sipping fine champagne on the Riviera. Rather, a credit boom makes stocks more and more overpriced until finally some realizer says, “Sell! I want my money.”
Thus are unleashed the dogs of panic.
STEPS OF A DEBT BOOM/BUST CYCLE
- Banks expand credit.
- Boom. New abundance of money lowers interest rates and misdirects capital into building capacity not needed.
- Bubble. Success begets excess. Excess debt begets overcapacity, overproduction, and bubble.
- Overcapacity kills cash flow so that the debt can’t be serviced.
- Bust. Panic rush for cash drives down prices of assets in overcapacity.
- Default. Debtors default, a default made inevitable by Step 1.
- Prices plummet a long time to liquidate overcapacity.
Originally published October 2018