Question

Need help on this question. Discuss  how the bond market reacts when the Federal Reserve increases short term interest rates. How do short-term versus long-term bond prices react? How do Treasury bonds versus corporate bonds behave?

Minimum of 175 words

Answer 1

Short term interest rates are set by Federal Reserve .If the short term interest rates are increased, it will cause shrinkage of supply of money and the cost of borrowing will become more expensive which would result in inflation and a fall in bond market .Market forces (demand and supply) determine the pricing of long term bonds which set long term interest rates. If the bond market believes that the Federal Reserve has set the rates too high, expectations of future rates would decrease which means that the long term interest rates decrease and vice versa.

Simply, when short term interest increases , it would result in decrease in future inflation and a fall in long term interest rates.

As we know that there is an inverse relationship between the interest rates and their respective bond prices. So the increase in short term interest rates would result a fall in prices of short term bonds . The increase in short term rates will result in decrease in long term rates which would ultimately result in increase in long term bond pricing.

When the short term interest rates are increased by Federal Reserve , the treasury bonds are often viewed as the safest investments and become more desirable by the investors. Correspondingly , the demand of corporate bonds will fall with fall in the bond market .