Lecture 5 - Money and Banking (The Bond Market)

Bond Market
Ryan Herzog, Ph.D.
Associate Professor Economics

Key Questions
• Why does bond demand slope downward?
• Why does bond supply slope upward?
• How are interest rates determined?
• Can we explain interest rate fluctuations?
7/5/2020 GONZAGA UNIVERSITY 2

Interest Rate Determination
• For simplicity we are going to look at “short-
term” and “long-term” interest rates
– Federal funds rate (determined by the Fed)
– 10-year bond rate (determined by the bond
market/market for loanable funds)

Bond Market
• The price of bond is determined through the
use of our present value formulas.
• Assume we are looking at a one year bond,
held until maturity, with a face value of
$1,000.
• Interest rates and bond prices are inversely
related.

Bond Supply
• The bond supply curve is the relationship
between the price and the quantity of bonds
people are willing to sell, all else equal.
• The higher the price of a bond, the larger the
quantity supplied.
• A higher bond prices means a lower interest
rates, more projects are profitable.
• As more projects become profitable, the quantity
of bonds being issued increases.

Theory of Asset Demand
• Wealth
• Expected Return
• Risk
• Liquidity

Wealth
• Wealth
– the total resources owned by the individual,
including all assets
• An increase in wealth gives us more resources
to purchase financial instruments and other
assets
• An increase in wealth increases the demand
for all assets

Expected Return
• The return expected over the next period on
one asset relative to alternative assets
• When a bonds expected return increases,
relatively, the demand for the bond increases
• Expected returns fluctuate due to changes in
interest rates and bond prices

Risk
• The degree of uncertainty associated with the
return on one asset relative to alternative assets
• If stocks increase in risk, investors will purchase
bonds
• An increase in relative risk decreases the demand
of that asset
• Risk increases as interest rates become more
volatile

Liquidity
• The ease and speed with which an asset can
be turned into cash relative to alternative
assets
• The increase in the speed in which an asset
can be converted to cash will increase the
quantity demanded of that asset
• Housing provides wealth, but it is not very
liquid

Bond Demand
• The bond demand curve is the relationship
between the price and the quantity of bonds that
investors demand, all else equal.
• The price of bonds is inversely related to the
yield, the demand curve implies that the higher
the demand for bonds, the higher the yield.
– A higher bond prices means a lower return to holding
the bond.
– A lower return means less people are willing to buy
bonds.

Shifts in Bond Demand
• Wealth (positive relationship)
• Expected Returns (positive relationship)
• Expected Inflation (negative relationship)
• Risk (negative relationship)
• Liquidity (positive relationship)
• International capital flows

Bond Supply
• The bond supply curve is the relationship
between the price and the quantity of bonds
people are willing to sell, all else equal.
• The higher the price of a bond, the larger the
quantity supplied.
• A higher bond prices means a lower interest
rates, more projects are profitable.
• As more projects become profitable, the quantity
of bonds being issued increases.

Shifts in Bond Supply
• Expected profitability of investment (positive)
– The more profitable an investment becomes the more
firm is willing to pay to borrow money
– When the economy is growing rapidly investment
opportunities are likely to be more profitable
• Expected inflation (positive)
– When expected inflation increases, real interest rates
and the cost of borrowing money decreases
• Government budget (positive)

Bond Market
• Occurs when the amount that people are willing to buy
(demand) equals the amount that people are willing to
sell (supply) at a given price
– When Bd = Bs → the equilibrium (or market clearing) price
and interest rate are set
– When Bd > Bs → excess demand, price will rise and
interest rate will fall
– When Bd < Bs → excess supply, price will fall and interest
rate will rise
• Equilibrium interest rates will change when bond
demand and/or bond supply change.

Supply and Demand in the
Market for Money
• Keynesian model that determines the equilibrium
interest rate in terms of the supply of and demand for
money.
• There are two main categories of assets that people
use to store their wealth:
money and bonds.
• Total wealth in the economy
= Bs + Ms = Bd+ Md
Rearranging: Bs − Bd = Ms − Md
• If the market for money is in equilibrium (Ms = Md ),
• then the bond market is also in equilibrium (Bs = Bd ).

Equilibrium in the Market for
Money

Supply and Demand in the
Market for Money
• Demand for money in the liquidity preference
framework:
– As the interest rate increases:
• The opportunity cost of holding money increases…
• The relative expected return of money decreases…
…and therefore the quantity demanded of money
decreases.

Changes in Equilibrium
Interest Rates
• Shifts in the demand for money:
– Income Effect: a higher level of income causes the
demand for money at each interest rate to
increase and the demand curve to shift to the
right
– Price-Level Effect: a rise in the price level causes
the demand for money at each interest rate to
increase and the demand curve to shift to the
right

Interest Rates
• Shifts in the supply of money:
– Assume that the supply of money is controlled by
the central bank.
– An increase in the money supply engineered by
the Federal Reserve will shift the supply curve for
money to the right.

Interest Rates

Response to a Change in
Income or the Price Level

Response to a Change in the
Money Supply

Money and Interest Rates
• A one time increase in the money supply will cause prices
to rise to a permanently higher level by the end of the year.
The interest rate will rise via the increased prices.
• Price-level effect remains even after prices have stopped
rising.
• A rising price level will raise interest rates because people
will expect inflation to be higher over the course of the
year. When the price level stops rising, expectations of
inflation will return to zero.
• Expected-inflation effect persists only as long as the price
level continues to rise.

Does a Higher Rate of Growth
of the Money Supply Lower
Interest Rates?
• Liquidity preference framework leads to the
conclusion that an increase in the money
supply will lower interest rates: the liquidity
effect.
• Income effect finds interest rates rising
because increasing the money supply is an
expansionary influence on the economy (the
demand curve shifts to the right).

Does a Higher Rate of Growth
of the Money Supply Lower
Interest Rates?
• Price-Level effect predicts an increase in the
money supply leads to a rise in interest rates
in response to the rise in the price level (the
demand curve shifts to the right).
• Expected-Inflation effect shows an increase in
interest rates because an increase in the
money supply may lead people to expect a
higher price level in the future (the demand
curve shifts to the right).

Response over
Time to an
Increase in
Money Supply
Growth

Money Growth (M2, Annual
Rate) and Interest Rates
(Three-Month Treasury Bills

Japanese Deflation
• Experienced negative inflation rates in the late 1990s
– Because of negative inflation rates the demand for real assets
(housing) fell, thus increasing the demand for bonds.
– Negative inflation rates also increased the real interest rates and
the cost of borrowing, thus decreasing the supply of bonds
• This caused a business cycle contraction
– Supply decreases further (shifts left)
– Demand shifts left, but by a smaller amount than supply shifts
• During contractions interest rates fall
• Caused negative interest rates on short term bonds

Monetary Policy and QE
• In November of 2008 the Federal Reserve announced a program
called quantitative easing.
• Quantitative easing (or credit easing) occurs when the central bank
participates in buying longer term bonds (government, asset
backed, or corporate) to lower interest rates.
– November 25th 2008, Fed announced they will purchase $600 billion
in agency debt and mortgage backed securities (QE1).
– March 19th 2009, Fed announced they are extending the program by
purchasing an additional $800 billion in securities.
– November 3rd 2010, Fed announced a new purchase program of $600
billion ($75 billion per month) (QE2).
• In the bond market this occurs through an increase in bond
demand. Bond prices will increase causing interest rates to fall.
• The yield curve should rotate downward.

QE

Monetary Policy and QE3
• QE3: Announced September 13, 2012, a new round of quantitative
easing provided for an open-ended commitment to purchase $40
billion agency mortgage-backed securities per month until the labor
market improves "substantially".
• The Federal Open Market Committee voted to expand its
quantitative easing program further on December 12, 2012. This
round continued to authorize up to $40 billion worth of agency
mortgage-backed securities per month and added $45 billion worth
of longer-term Treasury securities.
– On December 18, 2013 the Federal Reserve Open Market Committee
announced they would be tapering back on QE3 at a rate of $ 10
billion at each meeting.
– The Federal Reserve ended its monthly asset purchases program (QE3)
in October 2014, ten months after it began the tapering process.

Monetary Policy and
Operation Twist
• In September of 2011 the Federal Reserve announced Operation
Twist.
– They planned to purchase $400 billion of bonds with maturities of 6 to
30 years and to sell bonds with maturities less than 3 years
– The goal is to extend the average maturity of the Fed’s own portfolio
without increasing the overall amount of money in circulation.
• Operation Twist resulted in the Fed taken on a large amount of
interest rate risk. With record low interest rates it is safe to assume
rates for long-term maturities will increase causing prices to fall.
• In the bond market this is shown by an increase in bond demand for
long term bond and an increase in bond supply for short term
bonds.
• The effect on the yield curve is a rise in interest rates for short-term
bonds but a fall in interest rates for long-term,

Fed Policies – Following Great
Recession

Coronavirus Pandemic
• What’s going on today?

Why are Bonds Risky
• Risk arises because an investment has many
possible payoffs during the holding horizon.
We need to look at the risk the bondholder
faces, what are the possible payoffs, and how
likely each is to occur.

Bond Risk
• Default risk
– Tied to credit ratings
• Inflation risk
– Unexpected increases in inflation (or excess
volatility) lowers the real interest rate (increases
bond demand, decreases bond supply)
• Interest rate risk
– Unexpected changes in interest rate will create
risk to bond holder.

Default Risk
• Although there is little to no default risk with
U.S. Treasury bonds, there is with other
government and corporate bonds.

Inflation Risk
• With few exceptions, bonds promise to make
fixed-dollar payments.
• Remember that we care about the purchasing
power of our money, not the number of dollars.
• This means bondholders care about the real
interest rate.
• How does inflation risk affect the interest rate?

Inflation Risk
• Think of the interest rate having three
components:
– The real interest rate
– Expected inflation, and
– Compensation for inflation risk.
• Example:
– Real interest rate is 3 percent.
– Inflation could be either 1 percent or 3 percent.
– Expected inflation is 2 percent, with a standard
deviation of 1.0 percent.

Inflation Risk
• Nominal interest rate should equal
– = 3 percent real interest rate + 2 percent expected
inflation + Compensation for inflation risk
• The greater the inflation risk, the larger the
compensation for it.

Interest Rate Risk
• Interest-rate risk arises from the fact that investors
don’t know the holding period return of a long-term
bond.
• The longer the term of the bond, the larger the price
change for a given change in the interest rate.
• For investors with holding periods shorter than the
maturity of the bond, the potential for a change in
interest rates creates risk.
• The more likely the interest rates are to change during
the bondholders investment horizon, the larger the risk
of holding a bond.

Risk Structure of Interest
Rates
• Relationship among interest rates with the same
maturity but varying degrees of risk
• Default risk - Occurs when the issuer of the bond
is unable or unwilling to make interest payments
or pay off the face value
• Risk premium - The spread between the interest
rates on bonds with default risk and the interest
rates on T-bonds

Risk Premium and the
Economy
• We measure the risk premium by taking the
spread (difference) in a corporate bond (rated
Baa) and a 10 year treasury bonds
• We want two bonds with identical liquidity,
maturity, and tax treatment (the only
difference is risk).
• What happens during a recession (or the build
up to a recession).

FRED Exercise
• The Federal Reserve Bank of St. Louis publishes a weekly
index of financial stress (FRED code: STLFSI) that
summarizes strains in financial markets, including liquidity
problems. For the period beginning in 1994, plot this index
and, as a second line, the difference between the Baa
corporate bond yield (FRED code: WBAA) and the 10-year
U.S. Treasury bond yield (FRED code: WGS10YR).
– What does the difference between Baa corporate bond yields
and 10-year U.S. Treasury bond yields measure?
– What do you expect to happen to the spread in the two interest
rates during periods of financial stress
– Does the index STLFSI provide an early warning of stress?

FRED Exercise Part 2
• How did the Great Depression (1929–1933) and the Great
Recession of 2007–2009 affect expectations of corporate default?
To investigate, construct for each of those periods a separate plot of
the corporate bond yield spread. For the Depression period, plot
from 1930 to 1933 the difference between the Baa corporate bond
yield (FRED code: BAA) and the long-term government bond yield
(FRED code: LTGOVTBD). For the Great Recession, plot from 2007 to
2009 the difference between the Baa yield (FRED code: BAA) and
the 10-year Treasury bond yield (FRED code: GS10).
– How did the spread different between the two periods?
– In which period would you expect corporate bond defaults to be
greater?

FRED Exercise Part 3
• Measure the flight to quality by graphing the
relationship between the 10-year constant
maturity (U.S. bond) and Moody’s Baa
Corporate Bond Yield
– How did the risk premium change during the
Great Recession?
– What are the implications for small businesses,
households?

Lecture 5 - Money and Banking (The Bond Market)

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