I'm new to investment and trading and I was starting from square one when I signed up for RV. Lately there's been a lot of action in bonds, which are difficult to understand. But, understanding really gets you that trading galaxy brain. So I did a deep dive to understand how bonds work, and this is the result. Now I feel like I can understand what Raoul and Ed are talking about in RVDB. Please comment with corrections or further explanations.

 

HOW BOND YIELDS WORK

You pay $100 for a bond. It gives interest over time and then eventually pays you the $100 back. The total profit over time is the yield.

If you sell the bond on the secondary market, then when the price is lower, the total profit for owning the bond increases. Therefore, the yield increases.

When the price is higher, the total profit for owning the bond decreases, and yield decreases.

Thus, higher bond prices -> lower yield, and lower bond prices -> higher yield.

 

HOW THE TREASURY YIELD CURVE WORKS

The US Treasury (they make the dollars) auctions bonds (also called notes or bills depending on how long they take to mature) off to the highest bidder. The highest bidder could be anyone, including the Federal Reserve. Therefore, the prices of US Treasury bonds are entirely set by the market.

The number printed on the Treasury website is the YIELD. Higher numbers mean you can buy that bond for less. A yield of 1.00 means if you buy it for $100 then you will earn $1 over the next year. That number will be inversely correlated with the price of whatever Bonds ETF I buy for my 401k.

 

HOW THE FEDERAL FUNDS RATE WORKS

The fed is a central bank for the other major banks, like JPMorgan, BoA, whatever. Other banks can borrow from or deposit money into the fed. Banks may be required to borrow from other banks or the fed to meet minimum deposit requirements, and deposits they have with the fed are 100% guaranteed. Banks earn interest on all deposits with the fed. The federal funds rate is generally speaking both the interest that banks have to pay for loans from the fed or other banks, and the interest they earn for money deposited with the fed.

Turns out that depositing money with the fed and buying a short-term bond from the Treasury amount to basically the same thing, meaning that the shortest term Treasury bond always has a rate about the same as the federal funds rate.

Because the federal funds rate and bonds are the only 100% guaranteed source of interest for Dollars in the world, all other interest rates in the economy stem from them. (This is actually an amazing fact!) When you buy a CD, the bank takes your money and turns around and buys a treasury. They send some of the interest to you and pocket the difference. Fixed-rate mortgages tend to follow the 10 year bond rate (for some reason, even though mortgages are usually 30 year) because banks have the opportunity cost of buying the equivalent bond.

 

WHAT THE FED DOES WHEN THE ECONOMY IS STRONG

Economy is going up! There is inflation and the stock market is flying

This will create excess inflation, and the Fed's mission is to reduce inflation. So, the fed will RAISE the federal funds rate.

* This makes borrowing money more costly (eg to make risky investments with).

* This also makes the alternative of investing in loans and bonds more attractive.

These to factors suppress the stock market.

 

WHAT THE FED DOES WHEN THE ECONOMY IS WEAK

Economy is going down! Oh no there's deflation and the stock market is falling. This will create deflation or less inflation than the fed's target. So, the Fed will LOWER interest rates.

* This makes borrowing money less costly (eg easier to make risky investments).

* This also makes the alternative of buying loans and bonds less attractive, so investments prefer equity.

 

HOW DOES THE FED KEEP THE LONGER TERM BOND YIELDS WHERE IT WANTS THEM?

The federal reserve wants to keep the yield curve in a certain shape. To do so, it can BUY bonds directly from the Treasury. This increases the price and decreases the yield of the bond, making other investments better alternatives. Thus banks are more likely to make loans to individuals and businesses (stimulating the economy) and the stock market is more attractive.

When the fed does this, they give the Treasury money (where do they get it from? Poof they're the Federal Reserve, they just make it) and that bond goes on their balance sheet.

Fed can't SELL new bonds because the Treasury is the only one who can do that, but they can sell bonds previously purchased from the Treasury. They sometimes do this if they want to influence the yield curve.

The above process is called yield curve control.

 

WHAT HAPPENED IN 2008?

In 2008 there was a liquidity crisis. Significant defaults in mortgage-backed securities (MBS) caused banks to not have enough liquid capital to meet their debts. So, rather than purchasing from the Treasury, the fed and treasury purchased assets (loans, bonds) directly from the banks. Thus, the federal reserve and treasury balance sheets still contain a lot of MBS and other commercial bank securities, in exchange paid for by dollars that went to those banks. The toxic assets essentially got bought by the fed/treasury and then written off, to be eventually paid for later by tax dollars.

 

WHAT IS QUANTITATIVE EASING?

During QE the Fed skips the Treasury and purchases bonds directly from commercial banks. When doing so, it drives up the cost of bonds, thus lowering yields for that bond class. (It incidentally also reduces Treasury bond yields because commercial bonds compete on the open market with Treasury bonds.) The Fed pays for this by poof, making money out of thin air, which it can do because it is the Fed.

QE (and the purchasing of other assets like MBS in 2008) injects cash directly into commercial banks. If the banks turn around and lend that cash to others then it enters the economy and contributes to asset inflation.

Injecting cash and reducing the federal funds rates steepens the yield curve and so creates an incentive for commercial banks to use that cash to buy long-term treasuries. So QE also purchases long-term treasuries, driving down their yields, thus increasing the incentive for commercial banks to loan out their money into the economy. Individual consumers with low-interest bank accounts are now also incentivised to otherwise spend or invest their money.

After 12 years of doing QE, bond yields have been hammered into the ground and there has been a lot of inflation. These two factors have driven the stock market very, very hot, and made it increasingly difficult for the Fed to put the QE genie back in the bottle for fear of crashing the stock market. Yields are now well below inflation, meaning savings/CDs/bonds are no longer an effective way of keeping pace with inflation. The economy is currently in no condition to let interest rates rise again any time soon.