Bonds affect the U.S. economy by determining interest rates, which affect the amount of liquidity and determines how easy or difficult it is to buy things on credit or take out loans for cars, houses, or education. They impact how easily businesses can expand. In other words, bonds affect everything in the economy. Here's how.
Treasury bonds are essentially a loan to the government that is usually purchased by domestic consumers. They impact the economy by providing more 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, which allows Congress to spend more, which stimulates the economy and also increases the U.S. debt. The biggest owners of the U.S. debt are Japan, China, and the oil-exporting nations. The U.K. and Eurozone nations also hold a substantial amount of U.S. sovereign debt, as does Brazil.
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, which, 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 importantly, 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 mean lower interest rates on mortgages, which allows homeowners to afford more expensive homes.
Mortgages are riskier than many other types of bonds, because they have the longest durations, 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 that 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 upward 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 do. Why? Because they believe a recession will happen sooner rather than later.
Could the Bond Market Collapse?
The bond market can be subject to larger transaction costs for individual investors than the stock market. One reason is that while stock trading has largely moved online, where brokerages now offer free stock and ETF trades to most customers, many bonds are still bought and sold the old-fashioned way. Dealers still call their clients to offer individual bonds, or clients phone their brokers to place bond trades -- which adds to the cost of bond trading, especially for smaller investors.
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 that 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 it 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 performance is typical, because bonds drop when the stock market rises. Most of the drops in the bond market wouldn't even register as a market correction in the stock market.