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    The Macro Force of Bond Yields cover image

    The Macro Force of Bond Yields

    Table of contents

    1 | What is the bond market, and how does it work?2 | The difference between bonds & bond yields3 | Bonds look at Growth and inflation4 | The Chart of Truth5 | When growth peaks, yields peak6 | Monetary Policy: cutting rates/injecting liquidity7 | When growth deteriorates, bonds bid up  8 | Juicing the stock market9 | Kryptonite: high inflation kills bonds10 | Risk-off events11 | Summary

    The global financial system is a system of debt funding and the primary source of debt operates through the bond market.

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    1 | What is the bond market, and how does it work?

    The bond market is a market for fixed-income loans. A bond is a loan (contract) between an issuer (the seller) and an investor (the buyer). The buyer (investor) is essentially loaning x-amount of cash to the seller (issuer) to receive scheduled interest payments. The issuer gets to borrow money they don't have, and the investor gets scheduled payments. The investor (buyer) can always sell the bond to collect his principle, subject to price fluctuations.

    • Ex 1: If you need money to fund your lemonade stand, you issue a contract/bond to a friend that promises to pay them 5% of your monthly profits if they lend you $100. After the year is over, they would have collected 5% of your monthly profits times 12months. They also get their $100 back. As the bond issuer, you use the $100/loan to build a bigger lemonade stand to earn more money.
    • Ex 2: The U.S Government issues treasury bonds to fund projects such as social security payments, infrastructure roads, local projects, schools, airports, and factories. If you buy treasuries, you are loaning to the government and they pay you interest. Treasury bonds are considered the highest loan grade because the government has never defaulted on a payment.

    Size Matters
    • As of 2021, the U.S bond market was roughly $40 trillion in market cap, while the global bond market is ~ $120 trillion.
    • The bond market is huge, consisting of transactions between central banks, commercial banks, governments, municipals, corporations, sovereign wealth funds and institutional investors worldwide.
    • Foreign nations, central banks, and investors invest in U.S bonds, making it a globally accepted interest-yielding debt instrument.
    But what is a bond yield?

    2 | Bonds & bond yields

    A single bond has two separate values that move inverse to each other—first, the underlying price of the bond. The second is the interest rate that the bond yields to maturity. As the underlying bond increases in value, the yields decrease. As the bond decreases in value the yield increases.

    But why are bond yields so important?

    3 | Bonds look at growth and inflation 

    Bond investing is simple, it concerns two things; growth and inflation.Hand-n-handFirst, growth and inflation go hand n hand. 

    • Steady growth correlates with moderate inflation. 
    • Fast growth comes with higher levels of inflation. 
    Demand cycles
    • If growth is stagnant and inflation levels are low, bonds become attractive because they deliver fixed income.

    • The peak and fall of growth & inflation correlate to accelerating demand for bonds, and bond demand drives down yields/interest rates.
    • When the growth cycle bottoms, bond investors look for inflation to accelerate before selling bonds resulting in driving yields higher.

    4 | The Chart of Truth

    The stock market is erratic, but the bond market always tells the truth

    • Raoul Pal
    Bond yields are in a secular downtrendThe creation of debt between the Federal Reserve central bank and the U.S treasury department ensures there will always be a buyer of U.S treasury bonds.  The Fed creates money and loans it to commercial banks for 0% interest. Commercial banks loan the "free" money to the U.S treasury by buying treasury bonds creating an endless feedback loop of more debt and lower rates. The Fed can essentially lower rates by orchestrating an unlimited bid on U.S treasuries. Therefore, the secular trend of bond yields is likely to move lower in the long run.
    U.S 10y Treasury bond yields

    5 | When growth peaks, yields peak

    Because bonds provide fixed income to holders, they act as a safe haven against a recession or decelerating economic growth. Recessions can happen in two ways. In one case, there can be an unforeseen event that causes economic shock, and bond yields typically decline sharply until Monetary policy intervenes. In a more often case, it's more foreseeable because economic growth indicators begin to deteriorate, resulting in less confidence and making the system more vulnerable. Bond yields will usually decline at a more steady pace until policymakers intervene. 

    • 9/10 times bond yields and growth peak around the same time unless there's a real inflation concern.

    • As growth decelerates, the demand for bonds accelerates.

    What does it look like when policy makers intervene?

    6 | Monetary policy: cutting rates / injecting liquidity

    Under the conditions that central banks announce an emergency decision to lower borrowing rates (federal funds rate) and begin purchasing bonds, investors may see the current yield as attractive in anticipation of the underlying bond moving higher, which ultimately pushes yields lower.
    Cutting interest ratesAs the Fed cuts rates, bond yields decline on a long-term basis.

    • When the Fed starts cutting rates, bond yields initially decline until economic growth returns.
    • Think of rate-cutting as a delayed rescue to market risk. Bonds are attractive until the market believes the risks are gone.
    Injecting LiquidityNaturally, as the Fed increases treasury purchases, bond yields move lower.
    Never underestimate the structural forces of monetary policy. When the fed cut rates, it didn't matter where yields were. They dropped. When the Fed injected liquidity, it didn't matter how low yields were. They went lower. 
    Why does the Fed intervene?

    7 | When growth deteriorates, bonds bid up

    When PMI's are above 50, economic growth is considered to be improving, while under 50, economic growth deteriorates.

    • First economic growth peaks and bond yields decline.
    • Second, growth begins to deteriorate, bond yields move lower, and the fed cuts rates to prevent collapse.
    • Finally, growth returns, and the demand for bonds plummets, pushing yields higher. 

    Deteriorating growth hurts stocks, not bonds The stock market experiences significant correction when growth deteriorates the (PMI drops below 50)
    • When growth deteriorates, demand for stocks declines, while demand for bonds increases.
    • Following the 2008 Financial Crisis, bond yields never reached 3% again. Who is this buyer?
    RecapNever underestimate the cyclical force of economic growth. As growth deteriorates, stocks suffer, bonds perform, and eventually, the Fed steps in. ​

    8 | Juicing the stock market 

    Decades of lower bond yields have led to higher stock valuations.

    • ​Lower yields mean lower costs to service debt, leading to higher cash flows, higher earnings, and an overall higher stock market.

    • As the cost of capital (bond yields) cheapens over time, funding for innovation and economic growth also becomes cheaper.

    9 | Kryptonite: high inflation kills bond demand

    Inflation and growth move together. However, there are times when growth is stagnant, and inflation gets out of control. When this happens, bond yields can rise because the general cost of living rises faster than the potential interest on a bond. Inflation eats away at your buying power quicker than the bond can earn yield. But this is only if inflation is out of control which can be relative to the current era. If inflation is moderate, bonds will still look attractive in a slowing economic environment.

    • From the mid-'60s through the early-'80s, inflation went to all-time highs, and so did bond yields.
    • Although growth slowed in 2021, inflation reached 40-year highs, and bond yields followed.

    10 | Risk-off signals

    The ultimate risk-off events happen when demand for bonds and dollars accelerate together. Typically the bond market begins sniffing out risk then the risk-off combo happens.
    • 2008-09 Financial crisis 
    • 2009-12 European debt crisis

    In 2014 the introduction of shale shocked oil prices to the downside, causing a massive sell-off into dollars. When the largest commodity on earth sells off, it flows into the world reserve currency. A strong dollar makes U.S debt more attractive, thus, yields decline as bonds rise.

    • ​2014-15 oil shock
    • 2014 Russian financial crisis
    • 2015 Chinese stock market crash

    More Risk-off events

    • 2018 US/China Tariff war
    • 2018 monetary tightening
    • 2020 Covid 19 crisis


    • Bond yields are highly correlated to economic growth and inflation.
    • Bond yields are highly sensitive to the fed's decisions on monetary policy.
    • The secular decline in bond yields are highly correlated to the secular rise in debt creation.
    • Bonds act as a safe haven against economic slowdowns and recession.
    • Bonds suffer when inflation is out of control.
    • The ultimate risk-off events happen when both dollar and bond demand accelerate together.