We’ve thus far dedicated 2 articles to explaining what bonds are and how they function (The Bond Market and Bond Prices), so they must obviously be important in some sense of the word. Well, aside from serving as a popular and usually reliable investment vehicle, bonds are in fact crucial in the daily functioning of financial markets, both international and domestic. Today we’re going to look at bonds in the border context of national economies and how they can be used as various economic metrics.
The Fed and Bonds
We need to first recognize that there are really 2 kinds of bonds: corporate bonds and government bonds. The former is one of the main ways companies raise money (the other being selling shares) and the latter is how governments cover up for budget deficits. So when governments spend more than is taxed from the citizens, they need to somehow pay off the remaining debts. And what better way to do this than by selling these government bonds, often known as treasuries, to whomever will buy them?
So that’s what they’ll do. The bond interest rates will go up in order to spur demand for them and get the much-needed money coming in. Now curiously enough, in the US, one of the treasuries’ biggest customers is the Federal Reserve, the country’s central bank. Now the Fed is, well the Fed - arguably the most influential financial institution on Earth. Naturally, they also have some pretty serious buying power under their belts. This means that when they purchase treasuries, boy do they purchase a lot, we’re talking trillions of dollars worth. The Fed is not only helping the government out with its debt problems, it’s also putting downward pressure on bond interest rates.
This term, in the economic context, is what it sounds like; a price being pushed down from a force coming from “above” so to speak. The idea can be easily applied to simple supply and demand graphs. When there’s greater supply than there is demand, for example, that excess supply exerts downward pressure on the price of that good. On the flip side, if the demand for something exceeds its supply, this upward pressure on the price is exerted. But hang on, if the Fed is buying treasuries from the government, meaning it’s technically a customer, how can it exert downward pressure on the bond interest rates?
The reason has to do with Fed’s influence. You see, this financial institution can continually buy more and more treasuries such that it can almost control their interest rates at will, so it simply makes more sense to refer to this impact as pressure being exerted downwards. Now exactly why are bond interest rates lowered if the Fed starts buying a bunch of them? If the Fed didn’t create this downward pressure, the market forces of supply and demand would gradually raise the interest rates until profit-seeking actors (investment firms, individuals, etc) are willing to purchase the bonds.
Since the Fed is creating an “artificial demand” almost for treasuries, the interest rates are decreased; higher demand, lower interest rates. In short, the Fed executes one of its tasks of controlling bond interest rates by controlling how many treasuries they add to their shopping cart.
Risk, Interest Rates and the Cost of Money
Let’s look at this from the perspective of normal citizens for a moment: government bonds are by and large considered one of the safest assets available across most developed nations. If I’m lending my money to the American government through a T-bond, I’m lending my money to an entity that is considered to have the smallest risk of defaulting. So if we assume that government bonds have basically zero risk, then we turn to this concept called a risk-free rate, which is the interest you get for lending your money to a 0-risk borrower.
Even though the notion of a risk-free rate is hypothetical since technically no borrowers are without risk (yes, even the US government), US government bond rates are widely considered to be the closest thing we have in real life to a risk-free rate. This is another way of saying that US government bonds are the safest way to lend money, which means that all other borrowers are riskier entities to loan money to. And as greater risk is compensated through greater interest rates, all other entities borrowing money are charged a greater interest rate than the US government is for their issued bonds. The treasury bond interest rate is thus a baseline from which all other bond interest rates in the economy are set from.
So if US bond rates go up that essentially means that money itself throughout the economy has gotten more expensive. It becomes more costly for businesses to raise funds, more costly to mortgage a house, more costly to spend with credit cards, etc. All this decreased spending and investment leads to deflation: a general decline in prices.
So in addition to controlling required reserve ratios and the discount rate (the interest charged to banks on short-term, 24-hours-or-less loans. If the discount is high then banks have less access to liquid funds, which means they’re going to be more hesitant to lend money which means less spending), the Fed can also control inflation through bond interest rates.
How This All Relates to the Stock Market
Put simply, when bond rates go up, the stock market goes down. The reason is because as bond rates increase, they become a more attractive investment option since they offer higher reward. As such, people will sell stock and reinvest that money in bonds. On the other hand, if bond interest rates are low, people may turn to the stock market where they can potentially make some more money.
Keep in mind, however, that it’s more so the prospect of people turning to bonds with higher rates causing a decline in the stock market rather than people actually doing it. Government bond rates in particular offer comparatively low return on investment, and those bonds are usually for long-term investors. It’s not like hedge funds suddenly sell off their equities and flock to the US Treasury as soon as they hear that bond rates have increased by a percent.
Econ IRL
If only this was released during any of our 3 oligopoly articles (Oligopolies, Oligopolies Part 2 and Oligopolies Part 3). This week’s paper took advantage of a new entry into the French telecommunications market to conduct an empirical analysis on oligopolies. The economic theory posits that to counter new firms, the already dominant firm(s) may roll out their own rival brands instead of simply lowering their prices. When Intel was challenged by AMD in the CPU market, they introduced Celeron: a low-end microprocessor targeted for low-cost computers.
Now despite there being a bunch of theoretical work on dominant firms expanding their product lines in response to new firms, there’s surprisingly no empirical data on it. The French telecommunications industry was dominated by three firms, but after a fourth one entered the market, the first three almost immediately began providing low-cost services. The timing of this rollout strongly suggests that it was a strategic decision in the face of new competition. From the consumer point of view, this couldn’t have been better: the strategic product expansion resulted not only in lower prices, but also in added variety of telecom options.
‘Till next time,
SoBasically