Structure of interest rates is a concept that is very instrumental and significant in the determination of interest rates of bonds and their yields in any market. It is basically used in determination of the relationship between maturities and yields in a given bond market at any given time of operation.This relationship is often referred to as the yield-curve when it is plotted in form of a graph. This graph plots the yields of bonds that are similar in quality against their maturities from shortest to the longest.
Term Structure of Interest Rates in UK
Term structure of interest rate indicates the current yields being offered in the bond market at different maturities.This helps investors in comparing the yields on offer on short, medium and long-term bonds. It is thus a measure of the bond market expectations. This concept is used in the valuation of market’s expectation of interest rates in future based on the current conditions. The treasuries that are issued by the federal government are however considered free of any risks and thus generally have low interest rates.The yields are thus often used as the benchmarks for fixed income securities that have similar maturities.
The UK bond market is interesting to explore in relation to the term structure of interest rates. Expectations are considered to have great impact in the term structure of interest rates in the UK. The inflation regime of 1992 that followed speculative attacks for example led to the sterling pound being pushed out of the Exchange Rate Mechanism (ERM). In order to correct this, the Bank of England got and applied its autonomy and independence to set new interest rates to address the rising levels of inflation.This coincided with a break in the structure of dynamics of real GDP and inflation. The interest rates had to be hiked gradually to cushion the economy against the high rates of inflation that UK faced.
In discussing the term structure of interest rates in relation to UK, it is essential to consider the fact that the interest rates on different securities vary. This depends on the risk of default, the cost related to administering of the security, tax arrangements and the term of security. Different interest rates are charged to different borrowers depending on the potential risks of defaults involved. However, market arbitrage in UK has the effect of equalizing the risk-adjusted rate of return and not the rate itself. The structure of rates on the London money markets rise slightly as the risks associated with default also increases.
The risk of default has a great impact on the interest rates in the UK financial markets. When government bonds are considered in relation to default risks, it is ironical that default risks are almost non-existent. This is because the government can always raise the taxes or decide to print more money to enable it pay-off all its obligations in relation risks on bonds. The return on government-issued bonds is thus considered risk free. However, the return on corporate bonds is often higher than bonds issued by UK-Government. This is because when it comes to corporate investors, the risk of default is perceived to be greater.
The small loans in the UK financial markets are expensive to administer and also associated with high risks. Therefore, the interest rate charges that are involved in these transactions are generally high. Interest rate in the UK is regulated by the Bank of England.The bank generally has influence on short-term interest rates. This is used as a strategy to help the government manage inflation rates in the UK economy.
When inflation rate rises, the short-term interest rates are increased. Suspected fall in the interest rates in future after countering of inflation may lead to lower long-term rates than short-term rates. The Bank of England therefore plays a key role in setting the interest rates charged by financial institutions so as to regulate the amount of money in circulation. This protects both investors and consumers against the negativities of inflation. The term structure of interest rate in such circumstances would therefore be sloping downwards.
Influence of the Bank of England on Term Structure of Interest Rates
The Bank of England has great influence over the term structure of interest rates in the UK economy. The Bank has great control and influence on the level and structure of interest rates. This is effected through qualitative and quantitative restriction and regulation of bank lending rates. The Bank sets the interest rate at which all the financial institutions can borrow. This in turn affects the various lending rates that are set by the commercial banks, building societies and other institutions operating within the financial sector in UK.
The influence that the Bank of England has over the interest rates affects the price of all financial assets in the UK economy. This includes bonds, shares and the rate of exchange. These in turn impacts the consumer and then monetary demand. When the rates are lowered or raised, the spending activities in the entire economy are affected. When interest rates are reduced by the Bank of England, saving is lessened while borrowing is encouraged. On other an increase in the interest rates encourages saving and discourages borrowing. This helps in regulating the amount of money in circulation.
The BOE (Bank of England) is the sole supplier of cash in the entire banking system. It therefore determines the interest rate for all the financial institutions every day. This interest rate is consequently passed on to the entire financial system and the whole economy. When the Bank alters its dealing rate, all the commercial banks respond to this by changing their respective rates of lending to the financial institutions. The Bank of England is thus very influential in terms of determining the structure of interest rates on bonds and securities in the UK economy.
Monetary Policy and the Structure of Interest Rates
The Bank of England’s Monetary Policy Committee sets the interest rates for all financial institutions in the UK.This targets promotion of monetary stability and regulation of inflation rates in the entire economy. The monetary policy effects alterations in the base rate of the structure of interest. The policy works through fluctuations in the growth rate in monetary demand.
The Monetary Policy Committee sets the interest rates that all the financial institutions operate with in a particular period of time. The monetary policy works to regulate inflation rates. This fixed at 2% target. In order to achieve this target, money supply in the economy is regulated greatly. The policy controls growth of demand for money and not on bank lending and consumer credit. The monetary demand that influences inflation levels is regulated through interest rates or change in the cost of loans, bonds and securities.
The monetary policy in Britain is designed in such a manner that it is proactive to changes in the structures of the interest rates. It is designed with the framework and capacity to promote stability of interest rates over a given duration. This is meant to promote the confidence of consumers and investors in the market. The Bank of England’s monetary policy manages the exchange rate that also has an influence on the structure of interest rates in the UK economy. Management of the exchange rate has significant influence in the domestic monetary conditions in Britain. In order to maintain its monetary targets, the Bank often offsets its operations in foreign exchange.
The forward looking nature of the Bank’s monetary policy is strongly related to the maturity of the debt instruments. The structure of instruments thus contains the anticipations with regard to real activity and inflation in the future. The structure of interest rates that is regulated by the monetary policy thus helps the Monetary Policy Committee to control the inflation rates and regulate the monetary demand in the entire Britain.
The term structure of the interest rate is very critical in measuring key economic indices of a country. The rate of inflation and monetary demand in the UK economy is greatly regulated by the Bank of England’s monetary policy on structure of interest rate. The bonds and securities trading in the economy operate purely under the control of the term structure of the interest rates by the Bank. The Bank of England determines the interest rate that is charged by all the financial institutions that are trading in the economy. An increase in the rates discourages borrowing and promotes saving thus regulating the amount of money in circulation in the economy. Reduction of the interest rate on the other hand leads to rise in monetary demand.