Tuesday, June 11, 2013

Reasons Behind Bond Price Movement

Reasons for Bond Price rise (Both of these reasons are valid for the US Bond Bull market): 
  • Prices will rise if interest rates go down e.g. Federal Reserves lowers the interest rate or we have deflationary pressures.
  • Prices will rise if there is extra demand (supply/demand curve -  Higher Demand = Higher Price). This typically happens under two scenarios: 1- Economy is doing well, and people feel that they will get the returns promised by the country. As a result, they buy bonds as investment (Economic Confidence Trade). 2- Everything else is doing so bad that investors don't have any choice but to buy bonds (Fear/Safety/Risk off Trade).
Reasons for Bond Price Decline (Yield Rise):
  • Prices will decline if interest rates go up e.g. Federal Reserves increases the interest rate or there are inflationary pressures in the market. Inflation typically happens in a good/robust economy (not always).
  • Prices will decline if there is lesser demand (Supply/Demand curve -  Lower Demand = Lower Price). This typically happens under two scenarios: 1- Economy is doing very poorly, and people feel that they will not get their money back from the country. As a result, they will dump their bonds (This was seen in Europe in 2012, where the Bond prices fell along with the Stock Market, and the yields reached 6% for some countries, which had to seek bailout funds). 2- Everything else (commodities and stocks) are doing so good that investors don't have any choice but to sell bonds (Rotation/Risk on trade).
Based on the above mentioned explanation, lets analyze the U.S. Bond market. 

US Bond market has been going up because U.S. Bonds were considered safe haven during the financial crisis of 2008 and during the 2012 European crisis. This situation was further amplified by Federal Reserves extra low interest rate policy, and the subsequent QEs. Finally, there is a 30 year cycle in the Bond Markets. This cycle bottomed in 1980 and will be topping out soon. All of the above reasons have contributed towards a Bond Market's Bull run. 

At this point in time we are at a critical juncture in the Bond Market. On one hand Bond Prices have put in a Head and Shoulders pattern, which suggests that Bond prices are about to head much lower. And on the other hand, Bond prices are sitting at a long-term Moving Average support. If this support gives way to further decline, we can be assured that Bond Bull has come to an end. If this support holds, that would suggest another rally phase is approaching.

In both cases, U.S. economy might be headed for an interesting period. On one side, sharply higher interest rates will not only choke off economic activity in the long-run and put us back into recession territory, it might also suggest that global demand for U.S. bonds had declined, which could be very bad for our economy. And on the other side, sharply declining interest rates (increasing bond prices) could bring back deflationary fears. 

In short, we are approaching a very interesting period in the financial markets. Can you think of other ways to interpret Bond Market's price action? If so, please share in the comments section.

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