Question

It has recently been argued that UK pension funds have been buying increased amounts of longterm bonds to match their liabilities. What impact might this have on bond yields and prices at the long end of the yield curve? What might a Government’s policy response be to this? (Hint: you may want to think about this in terms of supply and demand for long dated bonds.)

Answer 1

Given: UK pension funds have been buying increased amounts of long term bonds to match their liabilities.

Impact on bond yields and prices at the long end of the yield curve:

• the demand for bonds will increase
• the bond demand curve to shift right
• it will increase the bond prices
• As a result, bond yields will be lowered in the long end

Government's policy response:

• Increase in demand for bonds will rise the prices as the supply of the bond is same. Hence, to control this situation, the government will increase the supply of bonds.
• In order to increase the supply of bonds, government will issue some fresh bonds.

note: Concept of demand and supply of bonds:

• The demand curve for bonds shifts because of changes in wealth, expected relative returns, hazard, and liquidity.
• Wealth, returns, and liquidity are emphatically identified with demand; chance is contrarily identified with demand.
• Wealth sets the general degree of demand. Speculators at that point exchange off hazard for returns and liquidity.
• The supply curve for bonds shifts because of changes in government budgets, inflation expectations, and general business conditions.
• Deficiencies cause governments to issue bonds and subsequently shift the bond supply curve right; surpluses have the contrary impact.
• Expected inflation drives businesses to issue bonds since inflation diminishes genuine getting costs, ceteris paribus; diminishes in expected inflation or flattening expectations have the contrary impact.
• Expectations of future general business conditions, including tax decreases, administrative cost decrease, and expanded financial development (monetary expansion or blast), actuate businesses to get (issue bonds), while higher taxes, all the more costly guidelines, and downturns shift the bond supply curve left.
• Hypothetically, regardless of whether a business expansion prompts higher loan fees or not relies upon the level of the shift in the bond supply and demand curves.
• An expansion will cause the bond supply curve to shift right, which alone will diminish bond costs (increment the loan fee).
• In any case, expansions likewise cause the demand for bonds to build (the bond demand curve to shift right), which has the impact of expanding bond costs (and consequently bringing down bond yields).
• Experimentally, the bond supply curve normally shifts a lot more remote than the bond demand curve, so the loan cost generally ascends during expansions and consistently falls during downturns.