How Bonds Affect the US Economy

They influence almost everything

Couple reviewing documents with an advisor
•••

Purestock/Getty Images

Bonds affect the U.S. economy by determining interest rates. This affects the amount of liquidity. This determines how easy or difficult it is to buy things on credit, take out loans for cars, houses, or education. It impacts how easily businesses can expand. In other words, bonds affect everything in the economy. Here's how.

Treasury Bonds

Treasury bonds are essentially a loan to the government that is usually purchased by domestic consumers. They impact the economy by providing extra spending money for the government and consumers.

For a variety of reasons, foreign governments purchase a large percentage of Treasury bonds. In effect, they are providing the U.S. government with a loan. This allows Congress to spend more, which stimulates the economy. It also increases the U.S. debt. The biggest owners of the U.S. debt are China, Japan, and the oil-exporting nations.

Treasury bonds also help the consumer. When there is a great demand for bonds, interest rates will be lower because the U.S. government doesn’t have to offer as much to attract buyers. This, in turn, affects interest rates for other bonds. Investors in Treasurys are also interested in the potential return on other bonds. If Treasury rates are too low, other bonds look like better investments. If Treasury rates rise, other bonds must also increase their rates to attract investors. 

Bonds and Mortgage Interest Rates

Most important, bonds affect mortgage interest rates. Bond investors can choose among all the different types of bonds, as well as mortgages sold on the secondary market. They are constantly comparing the risk vs. reward offered by interest rates. As a result, lower interest rates on bonds means lower interest rates on mortgages. This allows homeowners to afford more expensive homes. 

Mortgages are riskier than many other types of bonds because they are the longest duration, usually 15 years or 30 years. Therefore, investors generally compare them to long-term Treasurys, such as 10-year Treasury notes, 20-year bonds, or 30-year bonds. 

How to Use Bonds to Predict the Economy

Bonds have so much power over the economy that political consultant James Carville once said, "I used to think if there was reincarnation, I wanted to come back as the president or the pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody." 

Bonds' powerful relationship to the economy means you can also use them for forecasting. Bond yields tell you what investors think the economy will do. Normally, the yields on long-term notes are higher, because investors require more return in exchange for tying up their money for longer. In this case, the yield curve slopes up when looked at from left to right.

An inverted yield curve tells you that the economy is about to go into recession. That's when the yields on short-duration Treasury bills, like the one-month, six-month or one-year notes, are higher than the yields on long-term ones like 10-year or 30-year Treasury bonds.

That tells you that short-term investors demand a higher interest rate and more return on their investment than long-term investors. Why? Because they believe a recession will happen sooner rather than later.

Could the Bond Market Collapse?

The bond market is more susceptible to volatility than is the stock market. One reason is that most bonds are still bought and sold the old-fashioned way. Dealers call their clients to offer individual bonds. This adds to the cost of bond trading, especially for small investors. It can cost 50 to 100 times more for them to own bonds than stocks of the same company.

The stodginess of the bond market also increases its volatility. Investors cannot find the best prices quickly; they must call individual brokers. Similarly, dealers cannot sell large quantities of bonds efficiently. They must make several phone calls to find enough buyers. This inefficiency means prices can bounce around wildly depending on whether the dealer talks to a large or small buyer. Although electronic bond trading is on the rise, it remains to be seen how this might affect the market.

But this volatility does not mean the market is on the verge of collapse. Many factors make a bond market crash unlikely. The biggest of these is history. Since 1980, the bond market has only had four years with a negative return, including 2018. In three of those four years (1994, 1999, and 2013), the stock market did very well. This is typical because bonds drop when the stock market rises. In none of those years did the bond market lose more than 3%. A drop like that wouldn't even register as a market correction in the stock market.