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Interest rates & bond yields are positively correlated according to this: http://www.investopedia.com/ask/answers/04/031904.asp

Thus High interest rates => High bond yields

But at the same time, interest rate and inflation are negatively correlated according to this: http://www.investopedia.com/ask/answers/12/inflation-interest-rate-relationship.asp

Whilst inflation and bond yields are positively correlated according to this: http://www.investopedia.com/articles/bonds/09/bond-market-interest-rates.asp

Thus High interest rates => Deflation => Low bond yields


Can somebody help explain how to consolidate these seemingly contradictory statements?

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It is important to distinguish between cause and effect as well as the supply (saving) versus demand (borrowing) side of money to understand the relationship between interest rates, bond yields, and inflation.

What is mean by "interest rates" is usually based on the officially published rates determined by the central bank and is referenced to the overnight lending rate for meeting reserve requirements. In practice, what the means is, (for example) in the United States the Federal Reserve will have periodic meetings to determine whether to leave this rate alone or to raise or lower the rate. The new rate is generally determined by their assessment of current and forecast national and global economic conditions and factors in the votes of the various Regional Federal Reserve Presidents. If the Fed anticipates economic weakness they will tend to lower and keep rates lower, while when the economy seems to be overheated the tendency will be to raise rates.

Bond yields are also based on the expectation of future economic conditions, but as determined by market participants. At times the market will actually "lead" the Fed in bidding bond prices up or down, while at other times it will react after the Fed does. However, ignoring the varying time lag the two generally will track each other because they are really the same thing. The only difference is the participants which are collectively determining what the rates/yields are.

The inverse relationship between interest rates and inflation is the main reason for fluctuating rates in the first place. The Fed will tend to raise rates to try to slow inflation, and lower rates when it feels inflation is too low and economic growth should be stimulated. Likewise, when the economy is doing poorly there is both little inflationary pressure (driving interest rates down both in terms of what savers can accept to keep ahead of inflation and at) and depressed levels of borrowing (reduced demand for money, driving down rates to try to balance supply and demand), and the opposite is true when the economy is booming.

Bond yields are thus positively correlated to inflation because during periods of high inflation savers won't want to invest in bonds that don't provide them with an acceptable inflation adjusted yield. But high interest rates tend to have the effect or reining in inflation because it gets more costly for borrowers and thus puts a damper on new economic activity.

So to summarize,

  • high interest rates are positively correlated to high bond yields because the two are basically the same thing (one determined by central banks, the other by the market)
  • interest rates are negatively correlated to inflation because higher rates reduce demand for money (borrowing) and lower rates increase demand for money, which in turn (ceteris parabus) causes a lagging decrease or increase in inflation
  • inflation and yields are positively correlated because as inflation rises or falls, yields tend to rise or fall to keep supply of savings balanced to match demand.
  • So, and correct me if I'm mistaken, low interest rates lead to high inflation, which tends to raise bond yields, which then in turn raises interest rates which then leads to lower inflation? – kennyg May 1 '16 at 21:39
  • @kennyg That's the tendency (although it's not necessary high inflation, just higher) but of course rarely are all other things equal, so it doesn't always follow the neat "business cycle" definition. – Michael May 2 '16 at 2:19
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Imagine that the existing interest rate is 5%. So on a bond with face value of 100, you would be getting a $5 coupon implying a 5% yield.

Now, if let's say the interest rates go up to 10%, then a new bond issued with a face value of 100 will give you a coupon of $10 implying a 10% yield.

If someone in the bond market buys your bond after interest price adjustment, in order to make the 10% yield (which means that an investor typically targets at least the risk-free rate on his investments) he needs to buy your bond at $50 so that a $5 coupon can give a 10% yield.

The reverse happens when interest rates go down. I hope this somewhat clears the picture.

Yield = Coupon/Investment Amount

Update: Since the interest rate of the bond does not change after its issuance, the arbitrage in the interest rate is reflected in the market price of the bond. This helps in bringing back the yields of old bonds in-line with the freshly issued bonds.

  • Yes, that part is very much clear to me. It is the second two links that I posted that seem to contradict this statement (a.k.a. High interest -> Deflation -> Low bond yields). – kennyg Apr 24 '16 at 23:58
  • As I understand it, high interest rates lead to lower rates of lending, thus slower economic growth, thus deflation. Deflation (and this is the part that I might be wrong in) leads to lower yields, as a smaller yield is still profitable? – kennyg Apr 25 '16 at 0:05
  • Deflation of economy is a separate concept from 'inflation & deflation' that we typically measure in consumer and wholesale prices. This deflation is reduction in growth of economy. Higher interest rates lead to lesser capital investment (as loans become costly) in the economy and thus leading to a reduction in its growth rate. Deflation does not directly lead to lower yields. In fact, deflation itself is an outcome of higher yields. – John Locke Apr 25 '16 at 0:13
  • Could you possibly expand on that last statement about deflation being an outcome of higher yields? – kennyg Apr 25 '16 at 0:44
  • Maybe you could also shed some light on this quote by Colm O'Shea "A lot of people say there is apparently no inflationary threat from the growing U.S. debt because bond yields are low". Why would people correlate these two indicators? – kennyg Apr 25 '16 at 0:48
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Relatively bond prices are reversely correlated with coupon rates, which means that the higher the bond's prices, the lower the market rates. This might explain a reason why marketing inflation / deflation is negatively correlated to the bonds' prices.

(References are retrieved from the book Business Finance 12e - Peirson, Brown, Easton, Howard, Pinder, 2015)

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