Macroeconomics and the Bond Market
The bond market is a very important market to understand. Even if you’re not a bond investor trader, learning about the bond market as well as the macroeconomics that it drives will provide you great insights as to how this financial world really works.
What is a Bond?
A bond is simply a pledge from an entity to repay a debt that the investor buys from that entity. Most of the time, governments and corporations offer bonds to investors.
The payment of the bond comes with an interest, which should be fully paid by the time the bond matures.
Now, what are the underpinning macroeconomics of the bond market?
Central Bank Policies
Interest rate policies that come from the central bank are very important for bonds and the bond market since they determine the price of the bond for the issuers and the amount of return in the case of investors.
Needless to say, sometimes it’s difficult to invest in bonds because prime rates or key interest rates can change over time.
In other words, there will be times when it’s better to become the seller of the bond and there are times when it’s better to be the buyer.
Central Bank Policy Shifts
Central banks can move their target prime rate up or down, depending on what they deem is right to maintain the stability of an economy.
if the economic activity is too high, they increase the borrowing cost to control the growth. On the other hand, a very low economic activity can mean that the central bank should lower the rates to encourage business investment and spending.
For investors, this mean that they can short sell bonds when the rates are low and then buy them back when key rates are high.
Fighting Off Inflation
Inflation is the number one metric that central banks use to determine whether the economy doing good or bad. In other words, inflation highly affects the direction of the central bank’s policies.
Inflation refers to the speed at which the prices of goods and services move up. You can also apply this to many aspects of the economy.
Two of the most followed inflation measures are the Consumer Price Index (CPI) and the Producers Price Index (PPI).
The Labor Market Data
The labor market also plays a very crucial role in determining the inflation rate. Firstly, no economy can ever function if its workers are not working.
As for the central bank, the FOMC is mandated to keep inflation within their target range and ensure that employment is at a maximum sustainable level.
Because of the second mandate, the data from non-farm payrolls, unemployment, and average hourly earnings are very crucial.
Economic Activity and Bond Trading
Bond trading starts and ends with economic activity.
Think about it. When the economic activity is booming, investors and companies usually spend a lot to keep it going. But when the economy is performing poorly, investors typically ditch risky assets such as stocks and flock the perceived safer assets, which are typically bonds.