Think of the bond market as similar to the beach house rental market.
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Listener Susan Roe from Ames, Iowa, asks:
What causes bond prices to rise and fall? I understand the relationship between price and yield but what is the reason why prices rise?
If you can read its tea leaves correctly, the bond market will tell you a lot about the future of the economy. It gives us clues about where inflation is heading and whether a recession is looming.
Bond prices fall when their yield, or return on investment, goes up. We’ve seen a bond rally the past couple of months, which has driven annual yields down..
Let’s say you have a $100 U.S. Treasury note with a 5% interest rate. Bonds are fixed-income instruments, meaning their interest rates can’t change. If newly issued bonds pay 6% interest, your bond becomes less attractive, bringing its price down. You would have to sell it at a discount. But let’s say rates fall, and a newly issued bond comes with a 4% interest rate. Your bond is way more valuable to other investors, and you could sell it at a higher price.
So bond prices change because interest rates change. The market determines those interest rates, said Emory University finance professor T. Clifton Green.
“What affects rent on a beach house? How many other beach houses there are and how many tourists want to stay in the beach house,” Green said. Similarly, we can also “rent” out our money to others, he said. “That’s where interest rates come from. It’s just the rent on sharing this asset or letting someone use this asset.”
If there’s a lot of demand for a beach house, then the rent goes up. The forces of supply and demand affect those interest rates the same way. If a lot of people want to borrow money to start a new business or take out a student loan, and there aren’t many lenders, interest rates will go up and bond prices will go down. But if there’s not a lot of demand because people want to save money, and there are a lot of people willing to lend, interest rates go down and bond prices will go up.
Some people might think the Federal Reserve sets these rates directly. In fact, it only influences them. Long story short, the Fed adjusts its federal funds rate by setting a target range for the interest rate banks charge to lend each other money overnight. Banks then pass that cost along to consumers through higher interest rates or higher savings yields.
Fed policy will have a greater effect on yields for bonds with a shorter maturity, maybe 0 to two years, said Garrett Melson, portfolio strategist with Natixis Investment Managers Solutions.
News about inflation and the economy, like the monthly consumer price index report, will also affect bond yields and prices, Green said.
The yield on the benchmark 10-year Treasury note fell to 4.22% in early June, while its price rose.
“If you’re in an environment where growth is really falling, or moderating or cooling, and inflation is as well, then you’re probably going to see that yields are adjusting downward,” Melson said.
The consumer price index showed prices rose 3.3% year-over-year for May, lower than economists expected. Meanwhile, wholesale prices rose 2.2% compared to the previous year, which was also lower than expected. Based on this news, the market thinks that the Fed will lower its benchmark interest rate, which is why we’re seeing prices rise.
