Question

Provide a well-written essay of approximately 200 words. If bondholders expect the Fed to raise the interest rates what action(s) might the bondholders take?  You may also answer this by discussing what other individuals might due in this situation. (Hint: Remember the importance of expectations.)  Explain your rationale.  Express your opinion, with analysis in mind, not emotion.

Answer 1

If it is expected that Fed is going to increase the interest rates, then bond prices are going to fall, as there is an inverse relationship between the interest rates and price of the bonds. It will make existing bond holders to get less price if they sell it later. So, they will try to sell their bonds now to get a better price. It will increase the supply of bonds in the market, putting downward pressure upon the price of bonds and yield earned increases. Afterwards, the investors will invest in those bonds who are giving higher interest rates after the increase in interest rates. It will improve their yield earned. Other investors in the given situation, will also wait for the increase in interest rates. Since bonds are getting cheaper, then demand for money increases. It will also affect the demand and supply of loanable funds. Demand of these funds increases and interest rate also increases in that market. It makes supply to increase, but along the curve. So, with the expectations of what may be done by the Fed, the investors (potential as well as existing) take actions that bring the expected change.

In the above diagram, price decreases from P1 to P2 and interest rate increase from I1 to I2.