As I understand it, the US Treasury Department issues bonds to pay for the government's coronavirus rescue spending. I might have thought that such a large input to the fixed income market on the demand side would increase prices, i.e., that interest rates would rise.

This hasn't happened though, in fact, the opposite seems to have happened. For example, the yields on 10 year treasuries have gone down since the beginning of 2020 (ref).

Why is this happening?

  • $\begingroup$ Question not well-formed. Yields on sovereign bond is not the same as interest rate, which is set by the central bank. Issuing bonds is fiscal decision; interest rate is set by monetary policy. For the specific period in question, there is significant demand for US sovereign debt---flight to safety from investors as well as expansion of the Fed's QE balance sheet. Regarding QE, due to dollarization of the world economy, the Fed faces essentially no upper limit in printing money/absorbing treasury issuance. $\endgroup$ – Michael May 3 '20 at 11:54

One standard way of determining the fair value of a bond yield (for a country that controls the currency it borrows in) is to say that it is the sum of two factors.

  1. The expected (Geometric) average of the overnight rate (that is set by the central bank) over the life of the bond. This equals the expected return of holding money market instruments instead of the bond.
  2. A term premium, which is compensation for taking the returns risk associated with a bond instead of investing in money markets.

Under this view, the lack of a rise in bond yields is easily understood - almost no market participants expect rate hikes.

It should be noted that there are a variety of academic disagreements with the previous explanation. However, if you browse the FRED database, you will see that during recessions, bond yields fall and deficits rise. This is because the rate expectations view is much closer to reality than supply/demand arguments based on deficits being large.

There should be other related questions on this website, but I did not spot any that were directly useful.

FRED 10-year yield FRED Federal deficit

  • $\begingroup$ Just to clarify, are you saying that the bond market is not influenced by supply/demand? It's hard to imagine how any market could be immune to those sorts of effects, are there any articles etc discussing this that you would recommend for understanding this better? $\endgroup$ – sudo-nim Apr 29 '20 at 8:51
  • $\begingroup$ Yes, that is what the argument is. The problem with “supply and demand” story is that government spending creates an income flow that can be used to buy the debt. There’s an extremely large literature that tries to find between deficits and rising bond yields. At best, there is a small increase relative to rate expectations - which fall more. For more reading, I think you should do a web search under “rate expectations”. $\endgroup$ – Brian Romanchuk Apr 29 '20 at 12:08

While there certainly is some inflationary pressure from these measures, it seems like the missing demand and investment as well as the decrease in investments from both households and firms is offsetting this effect entirely.

However, this might change in the long run, when the lockdowns will be lifted. Some authors argue that we will be facing a strong increase in inflation when the lockdowns have been lifted (ref).

You might be interested in Blanchard's Vox EU blog post on this issue.

  • $\begingroup$ Interesting points here about inflation, but I'm not sure I see understand the connection to interest rates. I can see your point here about inflation: intuitively household and corporate spending are way down. Investors still want somewhere to park their money though, if anything I'd have thought there would be more demand for treasuries now. $\endgroup$ – sudo-nim Apr 27 '20 at 8:16

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