How Do Bonds Affect the US Economy?

Low interest rates
Low interest rates on bonds is like more money for borrowers. Photo: 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, and expand businesses. In other words, bonds affect everything in the economy. Here's how.

Treasury bonds impact the economy by providing extra spending money for the government and consumers.

This is because Treasury bonds are essentially a loan to the government that is usually purchased by domestic consumers.

However, for a variety of reasons, foreign governments have been purchasing a larger percentage of Treasury bonds, in effect providing the U.S. government with a loan. This allows the government to spend more, which stimulates the economy. For more, see Who Owns the U.S. Debt?

Treasury bonds also help the consumer. When there is a great demand for bonds, it lowers the interest rate because the U.S. government doesn’t have to offer as much to attract buyers. Lower interest rates on bonds means lower interest rates on mortgages. This allows homeowners to afford more expensive homes. How Do Treasury Notes Affect 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.

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

 How Do Bonds Affect Mortgage Interest Rates?

Bond 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." Wall Street Journal, February 25, 1993, p. A1.

How to Use Bonds to Predict the Economy

Bonds' powerful relationship to the economy means you can also use them for forecasting. That's because 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 a longer time. 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?

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. That's because stocks, and most other investments, are traded electronically. (Source: "When Will Bond Markets Join the 21st Century?" WSJ, June 5, 2015.) 

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