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Question 1160553: An article in the Wall Street Journal contained the following:
Prices of U.S. Treasury securities advanced Thursday as reports pointed to …easing consumer price pressures. It “looks like inflation fear is being taken off the table,” said Ira Jersey, an interest rate strategist at Credit Suisse in New York.
Explain why, if investors expect inflation to be lower, the prices of Treasury bonds will rise.
Answer by math_helper(2461)   (Show Source):
You can put this solution on YOUR website! Inflation == the deterioration of value of cash due to a general rise in prices. Example: If an item is subject to the nominal inflation rate, than 12 months from now that item will cost you MORE dollars.
Lower inflation outlook means interest rates drop. The reward (interest rate) is lower because the value of a dollar is not expected to erode as much in the future.
Bond yields drop in tandem... and a drop in bond yields means the price of the bond rises. Bond yields are similar to dividend yields on stocks: the higher the asset price, the lower the yield, and vice-versa. Bonds compete for fixed income investors, lower yields mean the bond yields can be lower and still attract investors.
Bond example:
Say there is a "4% 30yr bond." Institutional investors will buy them for the $100 face velue and get a 4% yield (a fixed payment of $4 for every $100 face value purchased). After that, purchases and sales are on the secondary market. On the secondary market, the price of the bond moves around. One factor that can move the bond price is interest rates. If rates drop after the bond was issued, investors might bid up the price of the bond causing the yield to drop
(if you pay MORE than $100 for the bond, the actual yield of that $4 payment is going to be LESS than 4%, this is called the current yield). It is worth mentioning, if you hold the bond to maturity, you get the $100 face value back from the issuer.
Sequence might go like this:
Initial offering of $100 face value at 4% ==> iniitial investors get $4/$100 or 4%.
Rates drop.
Institutional investor may sell some bonds asking $101 per bond.
Investor says to himself: $4/$101 = 3.96% That's pretty good, I'll buy!
Other institutions/investors see this price increase and may offer at $102
Some investors say: $4/$102 = 3.92%, still way better than alternatives, I'll buy!
The price/yield quickly finds an equilibrium.
The yields I've used are made-up. Current 30yr treasury yields are in the 1.6% range.
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