The fine links between Inflation, Interest Rates and Government Bonds

By 
Tim Clayton
Last Edited Apr 05, 2021

If you want something even broader than this you can have a look at our how the economy impacts currency rates guide or use our overvalued and undervalued economic calendar events guide. If you want to get the full picture and be able to forecast future currency rates accurately, we recommend you would also check our technical analysis guide for beginners.

Starting the story with inflation

Using the simplest approach ever, let’s understand the relationship between what could sound as complicated financial terms. As the global population keeps on growing, people have more and more needs and global demand increases. Every day that goes by, more people need to have access to housing, health & transportation services. Every day that goes by, more people want to travel, discover the world and experience new things.

 

As we all know, prices are the result of two market forces: supply and demand. As demand increases, prices increase and we see inflation. In other words, inflation is a natural process whose deep roots are related to the global population increase.  Now, at times not only the population increases but people get wealthier. As people get wealthier, they obviously consume more which boosts the increase in demand for goods and services.

To get a better idea about inflation, one should understand that there are two types of inflation. Demand-pull inflation (explained above) comes from higher demand. On the other hand, cost-push inflation results from higher costs especially energy-related ones (increased oil prices).

From https://fred.stlouisfed.org/series/FPCPITOTLZGUSA

So in every country, an institution called the Central Bank (FED in the US) will seek to avoid deflation and keep inflation under control. Indeed too much inflation (especially cost-push) leads to an unstable environment where people’s purchasing power gets affected and where disparities between rich and poor get bigger. So usually, developed countries’ central banks will target an inflation rate equal to 2%. In order to achieve this monetary policy objective, central banks will make use of various tools including the most important one: interest rates.

Moving to Interest Rates

So we all want to buy cheap and sell expensive. In the fixed-income world, we want to borrow at a low rate and earn savings when interest rates are high. Therefore, whenever inflation shoots up, the central bank will increase interest rates. As interest rates get to increase, we would be incentivized to earn on savings rather than borrow (no one wants to pay high-interest rates). As a logical result, people save money and borrow less – which decreases the supply of money in the economy. Therefore, with less money flowing, money becomes more scarce and therefore more valuable which reduces inflation.

From https://fred.stlouisfed.org/series/FEDFUNDS

Looking at the opposite scenario, let’s think that a country is getting into deflation. The first thing to say is that deflation is an extremely dangerous process that needs to be avoided at all costs. If you think that assets prices are going down, you do not invest and keep your money. As people behave in the same way, demand for goods and services decreases and deflation gets even worse. In other words, deflation gets countries into vicious circles. In order to avoid deflation, the central bank would reduce interest rates in order to incentivize spending and investment through borrowing.

So based on the economy’s health and future prospect, central banks will make use of the interest rates instrument in order to achieve target inflation rates.

Now as this process goes by, various financial instruments’ prices get affected. So let’s see how Government Bonds prices behave.

Impact on Government Bonds

One of the instruments raised by governments to finance their budgets is bonds. Obviously, Government Bonds are debt securities carrying a coupon payment (interest payment), that is in line with the country’s perceived level of inflation and default risk.  As we are not tackling credit risk, for now, we will be focusing on risk-free inflation-related risk. So let’s say that we are in December 2017 and the US Government issues a 10 years risk-free bond that has a fixed coupon of 2%. In other words, lenders will receive a yearly interest of 2% that will make up for the yearly expected inflation in the US.

Now let’s imagine that by 2018, inflation shoots up and the US Government decides to increase interest rates. As an investor, you are receiving a 2% interest rate within an environment where interest rates have increased and where inflation is getting higher. So the debt security that you own pays 2% when based on the current macro-economic context you would have expected to earn more than that. Obviously and given this, the value of your security will go down.

In the same way, should interest rates decreases, you would be receiving more interest than expected and the value of your security would go up.

So as a rule of the thumb, Government Bonds’ value goes up when interest rates go down and vice versa. This being said, Government Bonds’ prices are not solely affected by the risk-free rate. For most countries, credit risk is the main driver of debt securities’ prices…

From https://fred.stlouisfed.org/series/IRLTLT01USM156N

Summary: How does inflation impact interest rates and bonds

In summary, the relationship between inflation, interest rates, and government bonds is complex but can be understood through the basic principles of supply and demand. Inflation is a natural process that occurs as the global population grows and people’s needs increase. It can be caused by an increase in demand (demand-pull inflation) or an increase in costs (cost-push inflation). Central banks, such as the FED in the US, seek to keep inflation under control by adjusting interest rates.

When inflation increases, interest rates go up, which incentivizes people to save money and borrow less, reducing the supply of money and decreasing inflation. On the other hand, when a country is experiencing deflation, interest rates are reduced to incentivize borrowing and spending, in order to avoid a deflationary spiral. Government bonds are debt securities issued by governments to finance their budgets, and their prices are affected by the changes in interest rates set by the central bank.

 

More similar posts:

Cost of Living in Switzerland Vs UK

Cost of Living in Switzerland Vs UK

The UK and Switzerland are both exceptional countries that offer promising prospects for anyone looking to relocate. However, when it

Cost Of Living In Spain Vs UK

Cost Of Living In Spain Vs UK

When it comes to the cost of living in Spain versus the UK, it’s clear that the Spanish know how

Cost Of Living In New Zealand Vs USA

Cost Of Living In New Zealand Vs USA

Between New Zealand and the United States of America, the cost of living is cheaper by up to 22% in

Cost Of Living In Canada Vs UK

Cost Of Living In Canada Vs UK

Are you thinking about relocating to Canada or the UK and curious how much it will cost to live there?

Cost Of Living In Australia Vs Canada

Cost of Living in Australia Vs Canada

Whether you prefer the Land Down Under or the Great White North, both Australia and Canada offer a high standard

Cost Of Living In Australia Vs UK

Cost Of Living In Australia Vs UK

Australia and the UK offer compelling relocation options owing to their top-notch educational systems, high standards of living, and diverse

cost of living Spain vs USA

Cost Of Living In Spain Vs USA

The United States of America and Spain are among the best places to live in the world, but they are

cost of living France vs USA

Cost Of Living In France Vs USA

France is a treasure mine of history, stunning architecture, and delectable gastronomy. Living there comes at a steep price, which

cost of living australia vs US

Cost Of Living In Australia Vs US

The United States and Australia are two countries on the list of attractive destinations for international migrants. There are several

Cost of Living in Portugal vs USA

Cost of Living in Portugal vs USA

Depending on your personal needs and preferences, living in Portugal or the United States can be a wonderful experience. Although

Cost of living in Colorado vs Texas

Cost of living in Colorado vs Texas

Cowboys and rodeos, delicious food and beer served in generous amounts, and a Wild West heritage — Colorado and Texas

Economic Calendar UK

The table below, detailing the most important economic events that impact the economy and currency rates in 2023, can help

Brexit: Timeline, Impact and Aftermath

It’s January 31, 2023 and it’s been three years since the momentous occasion of Brexit. The United Kingdom’s departure from

Terrorism’s Impact on Economy

When there are terrorist attacks, globally, and they are making headlines , shocking the whole free world, many investors, workers,

Cost of living Florida vs California

Cost of living in Florida vs California

If you love the tropical climate and are keen on living the laidback beach life, you’re probably debating moving to

Cost of Living New Zealand Vs Australia

Cost Of Living In New Zealand Vs Australia

Australia and New Zealand are among the most popular choices for those looking to move to a country with a

technical-analysis

Technical Analysis for Beginners

If you understand the fundamentals of foreign exchange rates like economic indicators and wish to be able to do comprehensive

South African Emigration Patterns and Their Impact on the South African Economy

Recently it has become popular for the white population of South Africa to emigrate to other countries. Given that the

Major Historical & Economical Events Which Impacted Currency Rates

As long as people have been using money, economic events have had a major impact on humanity. History has been

interest rates

The fine links between Inflation, Interest Rates and Government Bonds

If you want something even broader than this you can have a look at our how the economy impacts currency

Economic Indicators

Undervalued and Overvalued Economic Indicators

Today, we will look at what I think are the three most useless economic indicators that investors and traders should

Oil Prices Impact on Currency Rates

Oil Prices Impact on Currency Rates and Economy

Changes in oil prices are a vital component for the global economy given the impact on both growth and inflation.

Currency Pegging

What is Currency Pegging and Is It Healthy for the Economy?

Various countries and governments around the world have been seeking to stabilize their countries’ economies by pegging their domestic currency

trade deficit

Trade Account: How Does it impact currencies?

A fundamental building block of currency valuations Although data can receive little attention for extended periods, the trade performance is

libor

What is the LIBOR rate and how does it impact currency rates?

The London Interbank Offered Rate (LIBOR) plays a key role in the global currency economy and in major currency events in

International Invoicing for SME's

International Invoicing for SME’s

Small and medium enterprises (SME) in the UK are increasingly trading on a global scale. Foreign trade allows them to