Question

why do investors believe interest rates in the future will be higher than current interest rates? in context to Pure expectations theory

Answer 1

Whether the interest rate movements are caused by Federal Reserve actions, economic conditions or inflation fears, the impact on the bond investor is the same: Rising interest rates reduce existing bond values and falling interest rates increase existing bond values. The price that a bond sells for in the market today is the sum of all future cash flows, discounted in value because they are not available today. A dollar tomorrow is worth less to you than a dollar today. The discount rate used is the rate of interest prevailing in the market for bonds of the same risk and maturity. When that interest rate changes, it affects the price of all bonds, but to varying degrees. The longer the maturity of your bond investments, the greater the price volatility. When the investment outlook is good, interest rates tend to move higher to compensate investors who could earn even higher returns in risky assets like stocks. But rates decline when investors have a lower risk appetite and higher demand for conservative and stable cash flow. Since longer-term debt investments involve greater risk than comparable shorter-term investments, long-term interest rates are typically higher than short-term interest rates. When bond prices rise, yields fall, and vice versa. Hence, when fear rises and money flows into bonds, it pushes prices higher and yields lower. Therefore, when the interest rates rise, bond prices fall, and bond investors, especially those who remain in bond funds, will feel some degree of pain. When consumers pay less in interest, this gives them more money to spend, which can create a ripple effect of increased spending throughout the economy. Businesses and farmers also benefit from lower interest rates, as it encourages them to make large equipment purchases due to the low cost of borrowing.