MAF202 Money and Capital Markets Assignment

MAF202 Money and Capital Markets Assignment

INTRODUCTION

Yield curve represents the annual investment return. Typically the yield curve is drawn on bonds taking the measures as purchase price and interest, coupons or payments received. The interest amount is fixed, but the bond price tends to change with the fluctuations in the interest rates, maturity, supply and demand and credit quality of the bond. Yield curve plays an important role of a leading indicator in economic activity. It is because the curve indicates thought process of investors for the direction of interest rates as economic expectations. In recent years, the yield curve has an appreciable role in estimation of economic conditions, signalling investors with recession and improvement (Desloires, 2015). The following report presents an overview of the changes taken place in the yield curve of Australia from a period of five years. Different indicators are used to assess the individual and comparative performance and the reasons behind that.

Task 1

1. Yield curve of Australia representing structure of interest rates

The five indicators used to measure the yield curve are explained as follows -

  • Cash rate target – The term is commonly used in Australia and New Zealand. It is the rate which is charged by the central bank on overnight loans to commercial banks. The monetary policy decision making is based on the target for cash rate (Martin, 2015). The interest rate and targets set enables the Reserve Banks in each of the nations to make necessary adjustments accordingly.
  • Interbank overnight cash rate – This measure is used for calculations by the Reserve Bank on data representing amount and weighted average rate at which the banks transacts in domestic interbank market for overnight unsecured funds (Chan, 2015).
  • 30 dayBABs/NCDs – The BAB stands for Bank Accepted Bills is a short term debt instrument issued by companies and that is guaranteed by a commercial bank. The instrument is purchased at face value, at a discounted rate. The full face value of the debt is paid on maturity (Angelini, 2011, pp.25-44). The difference between the purchase and face value is the interest earned and which is used of tax purposes.

Negotiable Certificates of Deposit range from 2 to 15 weeks duration with a minimum face value of $100,000. The CDs are bank guaranteed and are usually sold in liquid market.

For the purpose of analysis, three different CDs for maturity period of 30, 90 and 180 days are selected. All these variables represent the bond and debt market in short and long term duration. The relationship between levels of interest rates across different maturities is referred to as structure of interest rates (Baaquie, 2001). This structure is used for the examination of financial markets for decision making regarding monetary policy and investment.

1.2 Changes in the slope of yield curve

Interest rates and yields :- As evident from the chart drawn for the period of March 2010 to March 2015, yield curve has moved down, both in slop and level. The 180 days BABs/NCDs have declined by 49% in five year. Similar fall are also noticed in the 90 day BABs/NCDs with 47%. 30 days BABs/NCDs are also down by 45%. Cash rate target and Interbank Overnight Cash rate are down by 43%.
Cash Rate TargetInterbank Overnight Cash Rate30-day BABs/NCDs90-day BABs/NCDs180-day BABs/NCDs
Mar-20103.983.984.104.334.60
Mar-20152.252.252.272.302.34
-43%-43%-45%-47%-49%

Table 1: Interest rates and yields

[caption id="attachment_3273" align="alignnone" width="559"]Yield curve of interest rates in AustraliaInterest Rates and Yield[/caption]

Through close interpretation in the rates, it has been noticed that from March 2010 till July 2010, there is a period of continuous increase in all the variables. In August 2010, there is decline in all the variables. Things again improved from September and continued till next 10 months (Bužinskien? and Rudyt?, 2015, p.9). There are slight fluctuations during the period in all the variables, but all maintained a growth momentum and avoid huge decline. Since July 2011, there is continuous decline in all the variables, with few upsides but none of them moving above the previous duration high’s. The highest decline is seen in the longest maturity period i.e. 180 days BABs/NCDs with 49% (Dept, 2014). The lowest maturity has experienced the lowest fall among the other two.

Capital market yields

 
2 yrs3 yrs5 yrs10 yrs
Mar-20104.785.055.345.62
Mar-20151.831.831.982.48
Change in five years-62%-64%-63%-56%

Table 2: Capital Market Yields

[caption id="attachment_3274" align="alignnone" width="580"]It showcasing yield curve for capital markets of australiaCapital Market Yield[/caption]

Thecapital market yields have also collapsed by more than 50% in five year. As seen from the above table, the government bonds of 2, 3, 5 and 10 years are down by 62%, 64%, 63% and 56%, respectively. It can be seen from the above table, that 3 year government bonds have the largest fall while the 10 year have the lowest among all. This can be interpreted as investors were not confident for the short term period compared with the long term duration (Faugère and Van Erlach, 2009, pp.27-88). Therefore, long term bonds were able to gain investor confidence.

GDP growth
Year-ended real GDI growthYear-ended nominal GDP growthGDP deflator10 Year Government Bonds
Mar-20101.43.3243.85975.62
Mar-2015-0.21.2-469.4232.48
-118%-65%-56%

Table 3: GDP growth

The measure of GDP growth included for the analysis purpose are based on year ended real GDP growth and year ended nominal GDP growth. The difference between the two GDPs is that real values are inflation adjusted while nominal values are not. This is the reason that nominal values are higher than real values (McLean, 2012, pp.28-43). [caption id="attachment_3275" align="alignnone" width="585"]This yield curve consists gross domestic product of australia GDP Growth[/caption]

The real GDP growth for the year ended March 2010 was 1.2 which came down to -0.2 by the end of March 2015. The decline is measured at negative 118% at the five year ended. Similarly, the year ended nominal GDP for March 2010 was 3.3 which fall down by 2.1 points in five year to 1.2 on March 2015 (POKE and WELLS, 2009, pp.121-131). However the decline is comparatively less than the real GDP. The GDP growth was almost negative in March 2015, which is attributed to the rising inflation level in the economy.

The GDP deflator which is also an economic metric is also calculated to determine the level of inflation and deflation in the economy. The metric is obtained by dividing nominal GDP by real GDP for the same period (Shahiduzzaman and Alam, 2013, pp.323-344). Also, the indicator converts output at current prices into constant dollar GDP. The purpose is to analyse change in base year GDP with the change in price level. The interpretation of 243.85 values for GDP price deflator in 2010 is that average price level improved in the economy by 2.43 percent. In contrast to this, the -469.423 value for GDP deflator indicates that price level decreased by 4.69 percent in the economy (Stockhammar and Österholm, 2015).

1.3 Justifying reliability of the yield curve

 
Unemployment rate - percent10 yrs Government BondsNumber of Dwelling Units Approved
Mar-20105.55.6217144
Mar-20156.22.4819584
13%-56%14%

Table 4: Comparative performance indicators

Unemployment levels are commonly used indictor for economic condition of a country as measures the percentage of total labour force looking for full time employment is without work and are looking for jobs. As evident from the above table that unemployment rates are increased by 13% from the base year of March 2010. This percentage increase by more than 10% is an indication of poor economic growth.

[caption id="attachment_3276" align="alignnone" width="541"]It shows the number of dwellng units coveredBuilding Approvals[/caption]

Building approvals are data related with the residential and non residential building work above certain limits as approved in the particular month. This has been increasingly use as an economic indicator as it provides an estimation of future building activity. The above table shows change in the number of dwelling units approved in Australia in five year duration. In March 2010, there were 17144 building approvals which rose to 19584 in March 2015, marking an improvement of 14% (Desloires, 2015). The overall trend shows building approvals declined in between the time duration starting from Feb 2011 and continued till July 2012. The time duration is similar to the decline seen in structure of interest rates. The 10 year government bonds also experienced small fluctuation after Feb 2011.

[caption id="attachment_3277" align="alignnone" width="587"]It displays the performance indicationPerformance Indicators[/caption]

Comparing the change in all the variables, heavy fluctuations are evident in the building approvals. It can be concluded that these fluctuations influenced the employment rates and interest rates as investor lose confidence. The housing sector in Australia is among the largest in terms of GDP contribution and growth (Baaquie, 2001). Moreover the fluctuations are on monthly basis since February 2011 till September 2014. Although market and economy shows improvement long before the September 2014, but there were minor still few down times.

The changes in the interest rates decisions in downward trend since Feb 2011, was responded by the market in similar manner. Thus it can be concluded that interest rates changes has a direct impact on the overall economic performance of the country as investors lose confidence in all sectors (McLean, 2012, pp.28-43).

TASK 2

2.1 Effectiveness of monetary policy in the wake of economic and financial stress

After the markets are hit by Global Financial Crisis and European Debt Crisis, all economies have undergone significant rate cuts. In a similar move, Australia has also cut rates since March 2011. There are continuous changes in the interest rates with more than five times in a year. There are both positive and negative points in response with the rate cuts as unemployment rates have raised while building approvals are in improvement levels (Stockhammar and Österholm, 2015) .

From an economic point of view and GDP growth, there are some improvements; although effects have also changes over the time and it still requires more to see real benefits. The cash rates are already down by more than 50% in the five year duration. Despite this, there is clear evidence in the increasing demand levels. Looking at the 10 year GDP data, improvements can be seen from December 2010 to March 2012 (Faugère and Van Erlach, 2009, pp.27-88). Both real and nominal GDP increased to significance levels. Building approvals are also somewhat positive during this time. The housing sector among all the variables is the only one that has experienced positive growth momentum from the base level of March 2010. All other variables have undergone changes with few positive level improvements, but are still below the base year levels. This growth in housing segment can be attributed to the benefits of low interest rates. The households with heavy debt have leveraged the benefits of low interest rates and pay off their full debt much faster (Poke and Wells, 2009, pp.121-131). This may be considered as a response to weaker income growth. Thus, it cannot be said that interest rate cuts as part of monetary policy was completely a failure. The progress no doubt is still slower but positive growth cannot be ignored.

The interest rates and yield curve shows some progress around October 2014, but this was again minimised and fail to move higher points. The capital market yields and government bonds also undergone similar progress and had successfully maintained the levels, but again fall down in March 2015 (Angelini, 2011, pp.25-44).

The reason behind decline in Australian economic conditions after a marginal improvement can be attributed to the recent Greek Crisis. This is in addition to the slow economic growth in China. The world economies once linked with each other cannot remain aloof from even the minor changes in any of the nations. Moreover, Greek is part of the largest European Union while China is the largest economy. So, the situation of crisis in these countries again influenced the growth momentum in Australia. There have significant structural changes in the Australian in five year duration which has supported the growth in one or the other ways such as in terms of reducing house debts from the consumer ends. Thus the economy is now growing at a moderate pace while combating the risk in the other national and a larger international context (Bužinskien? and Rudyt?, 2015, p.9).

2.2 Conclusions and policy implications of the yield curves for investors

Cash Rate TargetInterbank Overnight Cash Rate30-day BABs/NCDs90-day BABs/NCDs180-day BABs/NCDs
Mar-20103.983.984.104.334.60
Mar-20152.252.252.272.302.34

Table 5: Interest Rate and Yields

2 yrs3 yrs5 yrs10 yrs
Mar-20104.785.055.345.62
Mar-20151.831.831.982.48
Change in five years-62%-64%-63%-56%

Table 6: Capital Market Yields

The interest rate difference between 30 days and 180 days BABs/NCDs can be used as an indicator for the country’s economic health. These indictors can be used with 2 and 10 year government bonds for long term forecasting. The yield curve is considered as positive with economic progress when short term interest rates are below the long term interest rates. This positive yield is an indication that favourable trends are ahead for the nation and continues for the long term (Desloires, 2015). In above analysis for yield curve for five year duration from March 2010 to March 2015, the short term interest rates lower than the long term interest rates. In first case, the interest rates of 30 days BABs/NCDs are 2.27 while the 180 days BABs/NCDs are 2.34. While comparing the 2 and 10 year treasury bonds, the interest rates of former is 1.83% while for the later it is 2.48, indicating higher points for the long term. The comparison clearly indicates encouraging movements ahead and which will remain for a longer time (Baaquie, 2001). Past year drifts may be discouraging with heavy fluctuations, but comparative analysis based on the short and long term debt instruments are explicitly favourable for investors as well as consumers.

Although there is slowdown in the economic progress, but slight inclination in all the variables cannot be ignored. The government bonds are at their lowest in five year duration which influenced investor decision to a great extent. Along with this, there are pleasing shifts in the bond yields which is an indication that yields are bouncing at the higher level.

The upside direction in Building Approvals are can be considered as support for all other variables. This is because the variable is directly related with the consumer market and the financial sector. The interest rate cuts have reduced the debt margins, thus lowering the overall burden which provides room for investment in other areas (Baaquie, 2001). The GDP growth in Australia is influenced by the factors ranging from exports, public investment and mining industry growth. The year 2014 is showing supportive trends in GDP and bond yields. From the beginning of 2015, the Greek crisis and sluggish growth in China market has impacted the international market. Thus, implications on Australian economy can be attributed to these factors. There were significant improvements noticed in the exports and GDP growth. Public spending is also reduced which can also be seen as constructive with the fact that consumers are consciously spending hard earned money and are preferring more savings. Thestock market trends are again linked with the international market and greatly influenced by the fluctuation in global economies. Therefore, it cannot be said that Australian economy is completely under threat of another crisis. The trends may be slow but are on the supportive direction.

REFERENCES

  • Angelini, E, 2011. Short-term forecasts of euro area GDP growth. The Econometrics Journal. 14(1). Pp. 25-44.
  • Baaquie, B., 2001. Quantum field theory of treasury bonds. Physical Review E. 64(1).
  • Bužinskien?, R. and Rudyt?, D., 2015. The Impact of Knowledge Generating Investment on GDP Growth. Economics and Business. 26. Pp. 9.
  • Dept, I., 2014. Australia. Washington: International Monetary Fund, pp. 8-9
  • Faugère, C. and Van Erlach, J., 2009. A Required Yield Theory of Stock Market Valuation and Treasury Yield Determination. Financial Markets, Institutions & Instruments. 18(1). Pp. 27-88.
  • McLean, I., 2012. Why Australia Prospered. Princeton: Princeton University Press., p.28-43
  • POKE, J. and WELLS, G., 2009. The Term Spread and GDP Growth in Australia. Economic Record. 85(269). Pp. 121-131.
  • Shahiduzzaman, M. and Alam, K., 2013. A reassessment of energy and GDP relationship: the case of Australia. Environ Dev Sustain. 16(2). Pp. 323-344.
  • Stockhammar, P. and Österholm, P., 2015. Effects of US policy uncertainty on Swedish GDP growth. Empir Econ, pp.132-176