Factors That Determine the Demand for Bonds - Essay Example

iii) Expected future interest rate and bond prices: If the expected interest rate is high, then the expected future price of bonds is low. Thus there will be a windfall loss if bonds are purchased. Thus, bond demand will be low. This also implies that if expected future bond prices are high, then the demand for bonds will rise and vice-versa.

1. iv) Expected inflation: Expected inflation has an adverse impact on bond demand. If there is an increase in expected inflation, bond demand will fall and vice versa.

1. v) Relative risk: If the risk associated with a bond increases relative to other assets the demand for that bond will fall. Analogously if there is a decline in the relative riskiness of a bond, its demand will increase.

1. vi) Relative liquidity: If there is an increase in the relative liquidity of a bond, i.e., if converting the bond into cash becomes relatively easier, the demand for it shall rise if other things remain the same and vice versa.

1. vi) Business-cycle movements: If the economy is undergoing a boom, there will be an increase in the demand for bonds. Similarly, the demand for bonds will fall if the economy is suffering a recessionary period.

3. 
   b) Analyse the following statement:
   “This week, the yield on the US Treasury note closed below 3%, a level not seen in 50 years. In the UK, the 10-year Gilt yield sits below 4% for the first time since 1961, according to UBS. Germany’s Bund yield is closing in on 3%. It seems that the big bond markets are starting to follow the path set by Japan in the 1990s”…” It is hard to understate how important the fall in long-term bond yields is. In the realm of government bonds, the 10-year notes are the benchmark and safest of safe-haven assets. The question is whether low rates will work this time. Back in 2003, when the 10-year note dipped to 3.07%, deflation was a false scare and within a couple of months, the 10-year had rebounded above 4.5%. This time, the threat of deflation is being taken more seriously. Should policymakers again avert that fate, bond yields may be primed for an explosive rise as fiscal spending plans and the expansion in money supply suggest inflation is the likely outcome”. [Source: Financial Times 28-Nov-2008]

Before commenting on the report it will be useful to note that as mentioned above bond demands (and thus investment) are induced by business cycle booms and dissuaded during recessions. However, during booms since the threat of inflation looms large, it is a natural counteracting force to the possibility of overinvestment. Similarly, during recessions, the adverse effect on the demand for bonds can be countered by the threat of deflation. Now, let's turn to the report.

The first and foremost point to note in this context is the date of the report. It is dated November 2008. Thus the US, UK, and German economies were in a recession, arguably the worst one since the great depression (This was during the heart of the global financial crisis). Thus, one should expect expansionary monetary policies during this time. Lower interest rates ideally stimulated investment demand and thus increase the effective demand which leads to an expansion in real aggregate output with a multiplier effect and thus employment as well. What is reported seems to be along the same lines of intention.

The current yields on US Treasury notes fell to a level that was a precedent in 50 years. Similarly, there was a decline in long-term yields in the UK economy (gilt) and Germany (bond yields).

However, for this policy to work, the falling bond yields have to be coupled with expected deflation. This is so because the lower the expectation regarding future inflation, the higher the interest rates. This implies a future fall in interest rates and thus a raise in the future price of bonds. Thus bond demands will increase because people would intend to cash in on this potential capital gain. This policy failed in Japan in the 1990s since there was a rise in future expected inflation and thus people chose not to invest in bonds. As a result, the intended effect was not engendered.

Thus the report notes that for the expansionary policies that have implied the reduction in government securities to be successful, the threat of a future deflation has to hold strong. That will curb the adverse impact of the recessionary pressure on demand for bonds. The hope is that since the threat of deflation is being taken more seriously, it is quite possible that demand for bonds and thus investments can be stimulated which might provide a much-needed boost to aggregate planned expenditures.