When we hear news that the Federal Reserve, the central bank in the United States, continues to buy bonds in a massive way, this is actually big and important news for the average investor to digest. This is because the purchase of bonds by any central bank, let alone the U.S. central bank which controls the money supply of the world’s reserve currency, forces the yield on longer-dated government bonds down.
This is because bond yields and bond prices are inversely related. (i.e. a bond paying 5% that trades for 75 cents on the dollar would effectively yield approximately 6.7%, but a bond with a 25% premium to face value would only yield 4%). The demand for government bonds, also known as risk free assets, tends to go up during crises as investors (especially institutional investors) scramble to safety, accelerating yield declines supported by large central bank purchases.
When bond buying increases due to increased demand or artificial monetary policy measures, declining government bond yields directly affect the risk-free rate, and therefore the cost for banks to lend money. This reduces mortgage rates, and thereby stimulates the economy due to higher disposable income for households with mortgages.
With long-dated (10 year) government bonds now yielding only a fraction of 1% (around 0.7% in the U.S. and 0.5% in Canada), rates are close to what many consider to be an effective lower bound, meaning increased bond buying (debt creation) is likely necessary to sustain these near-historically low interest rates for consumers.
Invest wisely, my friends.
