Introducing the Bond Market
The Bond Market is hugely important due to its direct relationship with money flow. It is a strong indicator of market and risk sentiment and can help us understand how investors are viewing both the current status and future prospects of global economies.
In a word, the bond market is where companies and governments are lent money. These organisations issue bonds, essentially an I.O.U with an interest and expiry data attached to detail how the bond will be repaid. These bonds can then be bought or sold on a secondary market, in which their price will fluctuate based on standard economic drivers.
When we refer to bonds, it’s specifically Government bonds and in particular US Government Bonds that we are referring to. These are the de-facto standard for bonds, the most frequently traded by a large margin and generally considered the benchmark for the value of money given the size and importance of the US economy.
To give you a recent history, the US Treasury Bonds made up the majority of the bond market in America until 2009. After the collapse of Lehmann Brothers in 2008 and the subsequent burst of the housing bubble and financial crash, the US economy tanked. In 6 quarters starting from 2008 Q1, the US saw 5 quarters of negative GBP growth, including 2008 Q4 and 2009 Q1 in which the economy shrunk by 8.66% and 4.49% respectively. In addition to slashing interest rates, the US Government realised that they needed more drastic measures in order to kickstart the economy, since they were experiencing something that hadn’t been seen since the Great Depression of the 1930s. In November 2008, the Fed announced the first round of Quantitative Easing, a policy intended to pump huge amounts of money into the economy by purchasing long term securities. The Fed initially pledged to invest $600bn and their hope was that this would encourage consumers to spend, incentivise business to grow and banks to lend.
Quantitative Easing had two major macro effects. The first was a heavy devaluation in the Dollar. At the start of the financial crash, trade activity severely reduced due to the gloomy sentiment that had taken over the markets and subsequent risk-averse nature of investors. This resulted in a fall in the supply of dollars across the world, which initially caused the value of the dollar to shoot up. When the Fed introduced QE in late 2008, we saw the effects very soon, as the Dollar came crashing back down. In its simplest form, an increased money supply leads to a fall in the value for that money since it is more easily accessible.
The second effect of QE is the one that we’re most interested, the distortion of the bond markets. This new money flowing into the US economy was artificial money, a result of direct government intervention. Changes to the currency and to bond prices therefore, didn’t occur due to a shift in market forces but as a direct result of this intervention. The bond market therefore didn’t represent the true underlying value of the money and since 2009, US Treasury bonds are still considered the universal benchmark, but are treated with a slight degree of caution because of this.
The US introduced the Unibond market in 2009 to provide a source of bonds that were free from intervention from the government. These bonds are issued by local governing bodies and will be tracked in our weekly reports through a commonly used ETF, the iShares National Muni Bond ETF (NYSEARCA:MUB).
From a sentiment point of view, bonds are considered ‘safe havens’. Because they’re issued by governments, they are relatively low risk investments and are a source of safety investors will flock to when market outlook is uncertain or negative.
To better understand bonds, we need to define some terminology:
Par Value - the face value of price of a bond. This is usually common denominations like $1000 or $10000.
Coupon - the interest paid on the bond. This is fixed at the time of issuing.
Maturity - the length of the bond, or the time during which the lender will be paid their interest. Once the maturity has expired, the lender will be paid back the par value in full.
Yield - the return you get on a bond. The simplest measure of yield is calculated as the monthly interest payment divided by the price of the bond.
The relationship between bond prices and yields in an important one. As bond prices rise, yields fall and vice versa and this can be better understood with an example.
Let’s say you buy a bond for $1000 par value. It had a 5% coupon and 10 year maturity. With these numbers, you’ll be paid $50 per year and then your $1000 par value will be returned at the end of the 10 years. The current yield therefore is also 5%, calculated as 50/1000.
Now, depending on supply and demand, the price of the bond will fluctuate on the secondary market. The price will change and therefore so will the yield, despite the fact that the coupon is fixed. If demand for bonds has fallen and you are forced to sell for less than $1000, let’s say for $800, the yield is now 6.25% (50/800). If the demand for bonds has risen and you can sell for more, maybe this time at $1200, the yield is now 4.17% (50/1200).
So how does all of this relate to the currency markets? Well, higher yields tend to attract more investors. Investors from around the world will trade their currencies for the US Dollar in order to purchase bonds and this will cause the value of the US Dollar to appreciate. This isn’t a perfect relationship, of course nothing in the financial markets is, because there are many other factors at play here. Given the dominance of the Dollar though, this is still a strong indicator that we can base our analysis off and I will provide a more detailed case study with charts in a later article to discuss exactly how we can use this relationship.
Despite Quantitative Easing distorting the Bond market, the US Treasury Bonds continue to be the benchmark for the value of money around the world. Given the Dollar dominance in our world economy, this is a hugely important market that we need to be aware of when trading currencies and also understanding the overall market sentiment of investors. At the end of the day, we’re looking to hop on the back of trends that big institutions that determine the trend of the markets are making and it’s these same institutions that inform us of their sentiment by moving money between bonds, equities, commodities and currencies. In the weekly report, I will include charts for the 5, 10 and 30 year Treasury bonds and also the Unibond ETF. Keep an eye out for a later article aswell, in which I dive deeper into the relationship between bond yields and the US Dollar.