Question

Notice the following model of a bond market. In each situation given, explain what happens to the bond price and yield and why. a) Expected inflation decreases b) The return on bonds falls relative to other assets c) The federal government deficit decreases

Answer 1

Introduction

Bonds are a form of debt which the government uses to finance its spending. Over time, as recession or inflation strikes the market, the Central Bank of a nation purchasing or selling bonds in the open market to provide liquidity or to take money away from the system.

For example, during a recession the currency in circulation is low, because of which the demand for goods and services also suffers. During this period the Federal Reserve purchases bonds in the market and increases the flow of money by supplying currency in return. The exact opposite happens in an inflation, wherein the Federal Reserve sells bonds and takes away money from the market.

The Bond market, operates in a simple demand and supply model like any other product or service and the case study has been detailed as follows: -

Case Specifics: -

A) Expected Inflation Decreases: -

If the inflation in a country is lower than normal, the government would not sell new bonds and the existing ones would also be withdrawn if it were to fall any further. This means that the government does not want people to invest their money and would rather expect them to consume more and demand more goods and services. They remove the incentive to purchase bonds by increasing the price and reducing supply so that people do not invest, but rather spend more money in the market to help in creating demand. It is important to note, that negative or less inflation happens, when the demand for goods and services remains low.

Further, we can conclude that bond prices rise as expected inflation decreases.

B) Return on Bonds Fall relative to other assets: -

If bonds become less lucrative for investors, meaning that their demand is lower due to lesser returns and supply is normal, the prices of bonds in return would fall. This is based on simple demand and supply economics and profitability. If consumers expect, that the profitability of their investment would be lower, they would prefer investing in other assets which give them higher yield in comparison to bonds. The prices of bonds would thus fall relative to other assets in this scenario.

C) Deficit Decreases: -

When the deficit of the government decreases it means that it has higher flow of capital in the form of tax collections and the relative spending is on the lower side. As a result of this, their need for capital is limited and thus, they reduce the interest rates on bonds and increase its price, as they do not require capital from sale of bonds at this time period and would not provide higher interest rates because of the same.

We can conclude by saying, that as the government’s availability of capital during this time increases, the government increases the price of bonds.

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