Seemingly contradictory relationship between bond yields and economic growth?

Question

I have a few seemingly contradictory ways of viewing the relationship between economic growth and bond yields:

1. Reductions in FFR are largely induced by IOER. Since IOER and bonds are competing investments, a reduction in IOER increases demand for bonds and therefore increases bond prices and reduces yields. Main idea: lower interest rates cause lower bond yields.

2. Economic growth occurs in low interest environments, so number one's "main idea" should hold: lower interest rates cause lower bond yields.

3. Economic growth leads to rising bond yields. From CNBC article:

"Bulls like Tchir insist that, in this case, the rise in bond yields is not a negative for stocks: “This time the rise in yields is coming from economic growth, stimulus, and infrastructure. All of that is good for stocks. That’s why this rise doesn’t scare me too much.”"

4. During times of slowing economic growth, demand for money decreases leading to reduced demand for loans and a resulting decrease in interest rates. This environment makes investors nervous so bonds become more attractive, driving up demand and therefore increasing price and reducing yield.

I am very confused about the relationship between interest rates and bond yields. I thought they moved in the same direction, but the above is confusing me. Any clarity? Thanks!

Answer 1

(Note: there were similar questions in the past, but I did not see an exact match.)

As used in this question, “interest rates” are the rate of interest associated with a policy rate or a deposit. A “yield” is the the rate of return on a bond given its purchase price. For a bond, since the payments are fixed, the yield moves inversely with price.

If we simplify to the case of a zero coupon bond that matures at time T (starting at $t=0$), the price is given as: $$ P(T) = e^{- \int_0^T f(t)dt}, $$ where $f(t)$ is the instantaneous forward rate. (Based on Rebanato’s “Interest-Rate Option Models”, page 6. Should be in any fixed income textbook.)

Put into words: the price of the bond is given by “averaging” the forward rates over the life of the bond. Higher forward rates implies a lower price (and hence, a higher yield).

The central bank “risk-free” rates for short maturities, and the instantaneous forward rate initially coincides with that rate. Further along the time axis, the forward rate is normally interpreted as the expected policy rate plus a term premium.

If economic growth is expected to be strong, market participants normally expect rate hikes. For example, that is the implied behaviour of “The Taylor Rule,” which the reader can easily find references for.

In a recession, it is entirely possible for the central bank to lower the policy rate, and market participants to expect a strong recovery, and forward rates rise. However, one can look at bond data to see that the policy rate and bond yields are roughly “correlated.”

As for the relationship to equity prices (which show up in the question), the situation is muddled and should be a separate question.