Interpreting the Indicators (part 2)
How to read the Indicators from Money Guide: Inflation Rates, Central Banks' Rates, Sovereign Bonds, Currency Exchange Rates
This is the second part of a series explaining the Money Guide Indicators. Parts 1 & 3 can be accessed as standalone posts through the Resources tab on the homepage or by clicking here:
As I wrote before, processed information for decision making can become “actionable intelligence”. Usually, the processing itself depends on context. Every report can’t contain every piece of contextual data, we have to rely on our knowledge for that. The Money Guide Indicators contain condensed information, that can be combined with contextual knowledge to convey a sense of the performance of different financial assets and economic sectors. Let’s dig in:
Inflation Rates
United States (US) Inflation
European Union (EU) Inflation
Mexico (MX) Inflation
High inflation ▲=🔴 negative
Low inflation ▼=🟢 positive
”Inflation” refers to a general increase in the prices of goods and services in an economy. Inflation rates express the relative change of prices during a particular period of time. In general terms, inflation decreases the purchasing power of money (currencies). However, low rates of inflation have been used as a design feature of modern economies and not as a bug or an undesired consequence:
Inflation encourages spending of money. If I knew my money would be more valuable a year from now, I would be reluctant to spend it. If I knew my money would be less valuable a year from now, I would be hard pressed to find some good use for it, either spending it or investing it.
Inflation increases employment. When money gets cheaper (by losing purchasing power), employers receive more money for their products, and are more prone to hiring more people, even of those salaries are lower on real purchasing terms.
Inflation helps the government to get funded with cheaper debt. When general prices rise, also the prices of bonds (debt) rise. Higher bond prices means the government can get $100 (or close to that) for each $100 of debt bonds that it sells, instead of less. If it gets less, it would still have to pay back $100 in full. It also means lower yields on those bonds ($100 only yields $1, instead of $98 yielding $1). And, in the long run, it makes it easier for the government to raise more cheap money (through taxes and other income) to pay back the old debts.
Central Banks’ Rates
United States (US) Funds Rate
European Union (EU) Funds Rate
Mexico (MX) Funds Rate
High Funds rates ▲=🔴 negative
Low Funds rates ▼=🟢 positive
Central Banks control the supply of money by issuing their sovereign currency. The price of that money is the interest rate charged to borrow it. Central Banks rise or lower the Funds Rate, which is the rate at which banks lend money to each other. All other rates are dependent on that one, because each step adds additional interest until it gets to mortgages, credit card rates, commercial loans, etcetera. Usually, the main mandate of Central Banks is price stability (controlling inflation). When inflation is low, Central Banks can stimulate economic growth:
By raising rates, money becomes more expensive to borrow, and interest makes money more valuable. The overall result is a reduction on the general economic activity, and the market forces that normally push prices higher (investing, development and supply/demand dynamics). The common consequences are: unemployment (as explained by the Phillips Curve) and prices dropping (including commodities, products, services, bonds, stocks, and almost everything else).
By lowering rates, money becomes cheaper to borrow, and low interest makes money less attractive. The overall result is an increase on the general economic activity, and the market forces that normally push prices higher (investing, development and supply/demand dynamics). The common consequences are: high employment (as explained by the Phillips Curve) and prices rising (including commodities, products, services, bonds, stocks, and almost everything else).
Sovereign Bonds
United States (US) 2 Year Treasury Note
United States (US) 10 Year Treasury Note
Mexico (MX) 1 year Treasury Certificates (Cetes)
High Yields ▲=🔴 negative
Low Yields ▼=🟢 positive
Governments have a few main sources of income: taxes, sales of natural resources, returns on investments and debt. Sovereign bonds are debt securities issued by a national government to raise money for financing its needs (investments, programs, expenses, debt payments). Governments pay back the borrowed capital and interests to the bondholders, according to the specified timeframes of each bond. Usually, longer dated bonds have higher interest rates than shorter dated ones, because the bondholder’s capital is tied up for a longer period and can’t be used for other opportunities that might arise during that time, and because the borrower doesn’t need to refinance constantly the debt and be subject to eventual higher rates.
Bond prices move opposite to Bond yields. If a $100 bond pays a $1 annual interest coupon for 10 years, the $100 capital will be returned to the bondholder after the 10 year period, and the total return will be $10 (1% annual rate). If the same $100 bond is sold for $50, it will still pay a $1 annual interest coupon for 10 years, the $100 capital will be returned to the bondholder after the 10 year period, and the total return will be $60 (close to 8% annual rate).
Sovereign Bonds’ yields and prices are closely related to Central Bank Fund Rates, because the main Sovereign Bond buyers are Central Banks, and their supply of money is guaranteed by the assets they buy in exchange for that money.
Bond prices reflect supply and demand dynamics. When yields are not attractive, prices go down and vice versa:
Attractive yields are a sign of high interest rates and low economic activity. Capital is drawn to Bonds and is not available for other types of investments.
Unattractive yields are a sign of low interest rates and high economic activity. Capital is drawn to riskier investments with a better risk/reward profile and there is more capital available.
Currency Exchange Rates
US Dollar (DXY) Index
European Union EURO (EUR) vs United States Dollar (USD)
United States Dollar (USD) vs Mexican Peso (MXN)
Higher USD Prices ▲=🔴 negative
Lower USD Prices ▼=🟢 positive
Sovereign Currencies are supplied by Central Banks, and their value is supported by the discounted cash-flow value of the bonds and assets held by those banks. Their price is also subject to supply and demand dynamics, and perceived strength of the respected countries and governments.
Since the Bretton Woods Agreement, all currencies are pegged to the US Dollar. In general terms, all currencies move opposite to the USD, affecting the pricing of almost all international assets.
Most countries try to have a trade balance surplus (more exports than imports), which translates to more resources going in than going out:
Stronger national currencies make imports cheaper and exports less attractive. Goods from other countries can be bought with less local currency, but exports will be harder to sell and will bring less local money (that can be exchanged for more local goods).
Weaker national currencies make imports more expensive and exports more attractive. Goods from other countries have to be bought with more currency, but exports will be easier to sell and will bring more local money (that can be exchanged for more local goods).
Inflation, Funds Rates, Sovereign Bonds and Currencies are very closely related. In the next part of this series I will be explaining the other components of the Money Guide Indicators (Commodities, Stocks, Crypto) and what their behaviors convey about themselves and the economy as a whole.
-SM
Part 3 of this series can be accessed as a standalone post through the Resources tab on the homepage or by clicking here:
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