What the demand and supply imbalance in bond markets implies for investors

Market Realist

Supply, demand, and interest rates: Why 1 thing leads to another (Part 3 of 3)

(Continued from Part 2)

  • The demand we have seen for fixed income this year is a significant contributor to lower interest rates. The demand is coming from retail investors through mutual funds and ETFs, as well as institutions and government bodies like the Fed.
  • Changes in this supply/demand picture will go a long way towards determining where rates go, especially shifts by central banks. As Russ recently pointed out, the Fed is now midway through their tapering down of Treasury and MBS purchases, and our expectation is that they will have ended the program by the end of the year. This is in contrast to Japan, which continues their asset purchase program, and the ECB, which stepped up last week to increase liquidity and may be moving towards a form of QE. Even when the Fed is out of the picture, continued strong bond demand from foreign central banks and investors could keep rates in a low range. We believe that the 10 year US Treasury will likely move towards 3% by year end, but it’s doubtful that it will rise significantly above that level. The supply/demand picture just doesn’t make this likely. Yes the Fed will continue to taper, but other investors are expected to step in and fill the gap. The Fed isn’t the only bond player in town.

Matt Tucker, CFA, is the iShares Head of Fixed Income Strategy.

Market Realist – When central banks make changes to their monetary policy, the markets react by adjusting the yields to match the expectations of how the yield curve may move in the future. The changes in interest rates affect demand and supply dynamics, as the desirability of owning bonds changes. This in turn affects yields until the market establishes an equilibrium.

Market Realist – The effect of monetary stimulus depends on the market’s interpretation. Back in 2010, when QE2 was announced, yields actually increased rather than decreasing as many would have expected. The reason was that the market interpreted the move as inflationary and therefore adjusted the long-term rates expectations accordingly. Additionally, the unprecedented deficit of the U.S. balance sheet had investors demanding a higher premium for investing in Treasuries.

To learn more about how monetary policy affects interest rates, please read How does the Fed’s monetary policy affect the yield curve?

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