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Musings of a Philadelphia Physician who has served the community for six decades

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Whither, Federal Reserve? (1) Before Our Crash
The Federal Reserve seems to be a big black box, containing magic. In fact, its high-wire acrobatics must not be allowed to fail. Nevertheless, it may be time to consider revising or replacing it.

Bonds are Up: Is That a Good Thing?

{Federal Reserve Bank of Philadelphia}
Federal Reserve Bank of Philadelphia

Bonds are part of a collection called fixed income investments. They have their advantages, but one great disadvantage is that they are a zero-sum contract. If both the investor and the issuer hold the bond to its stated maturity and are completely satisfied with the interest rate during the entire time, then it is just a contract whose terms please both parties. But if, as quite often happens, one party profits more than originally expected, then the other must lose an equal amount. If inflation makes the bond worth less to the holder, then the bond issuer can pay him back in cheaper dollars and is happy about it. If interest rates go down in a recession, then the reverse is true. The most unhappy situation for investors is to have the bond lack "call protection" and be redeemed earlier than expected, but at a moment that is to the advantage of the issuer.

Common stock, by the way, is not like that. It entitles you to a piece of the ownership of a company which works for you, and your interests will be parallel in wanting the company to succeed. When you buy or sell stock, it is possible for both sides of the transaction to be pleased with the result. Or you both can be displeased, but neither should feel victimized by the other.

With bonds, it is often the case that newspaper reports seem ambiguous. When bonds go "up", sometimes it means interest rates go up, which pleases investors, displeases issuers. Unfortunately, when interest rates go up, the sale price of the principal must go down to remain in harmony with current market conditions. So, a rise in interest rate pleases those investors who are looking to buy, but disappoints those who bought their bonds earlier and might be looking to sell. Note the multiplier here. Depending on the duration of the bond, a change of one percent in the interest rate might imply a ten-percent change in the principle. Stated another way, it takes a ton of money to affect prevailing interest rates very much.

There's one exceptional situation in fixed income markets, the viewpoint of the Federal Reserve, in charge of the money supply. To the Fed, rising short-term money market interest rates imply a scarcity of money, which the Fed can correct by printing more money. That's only a metaphorical expression; what it really does is set a lower interest target for short-term Treasury bills, which the Treasury Secretary dutifully announces. Flooding the country with money will reduce its scarcity, thereby lowering prevailing money-market interest rates. To repeat: money market interest rates are too high, the Fed announces they should be lower, the Treasury makes it happen. The Fed also has the ability to urge banks to do more lending, through reducing the amount of reserves the banks are required to maintain, in the current partial-reserving system of bank regulation. In the one case, there is more money, in the other case there is more credit; there's scarcely any practical difference. The reserving method is more useful during times of inflation when there is too much money in circulation. It's easier to print money than to get rid of money once it has been printed, so in that case more reliance is placed on raising bank reserve requirements.

All of this comes down to saying that interest rates reflect the scarcity of money. It is possible to adjust interest rates up or down in order to affect the scarcity of money. It is possible, even more common, to adjust the availability of money in order to cause a reverse effect on interest rates. They will go in opposite directions, no matter what action is taken, or in which direction.

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Government Bond prices are up; corporates of many sorts, particularly the "high yield" sort, are being carried out along with the foolish people who invested in them.
Posted by: G4   |   Feb 11, 2008 2:38 PM

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