Financial Crisis and Bond Market

Readers Question: How did the financial crisis affect stock markets and bond markets?

Stock markets were first hit by the instability in credit markets.

FTSE_100_index
Source: Thrapper, wikipedia. CC-SA-BY 3.0

When financial markets realised the credit crunch would impact on the wider economy, shares in companies fell further. This is a typical response. When economies enter into a recession, firms make less profit (or loss), and so firms pay lower dividends. This makes shares less attractive.

However, on the prospect of recovery, shares had bounced back from their nadir in November 2008.

The US stock market recovered even more strongly due to higher growth in the US.

The bond market is different to the stock market. Government bonds are seen as a ‘safe investment’. Generally, in a period of uncertainty, investors prefer safe investments like government bonds. With shares, a firm could go bust. But, with government bonds – historically, they are safe.

Therefore, at the height of the credit crunch, there was strong demand for government bonds as people looked for security.

10-year-bond-yields
10 year bond yield in UK. Bond yields fell from financial crisis of 2007/08 – due to liquidity trap and demand for safe government assets.

Government bonds have also been influenced by the policy of quantitative easing. This involves the creation of money to buy assets such as government bonds. Therefore Central Banks, especially the Bank of England, have been increasing their holding of government bonds. This has caused the price of bonds to rise, due to the increased demand.

However, the outlook for government bonds is more complicated.

Firstly, the recession and financial bailout have caused government borrowing to increase substantially. Therefore, there will be a lot of bonds; governments will be trying to sell. If the debt becomes too large, it may put upward pressure on interest rates and reduce the value of bonds. However, debt needs to become very high and unsustainable for this to occur.

bond-yields-net-debt
During great recession (2008-15) Higher debt in UK led to lower bond yields

Also, there will come a time when the economy recovers and the Central Banks halt and then reverse their policy of quantitative easing. This will involve selling their holdings of bonds on the open market. Combined with large fiscal deficits it is uncertain whether the market will have much appetite for the huge quantity of government bonds. Therefore, the price of bonds may fall.

EU bond yields

eu-bond-yields

In the Eurozone, the financial crisis led to higher bond yields. This was because in the Eurozone, countries like Spain, Greece and Portugal did not have an independent monetary policy. This caused higher bond yields due to liquidity shortages. Intervention by the ECB helped to reduce bond yields after 2012.

Some people, even talk of a new bond bubble. – Bond prices rising more than they deserve.

Related

By on November 11th, 2015

2 thoughts on “Financial Crisis and Bond Market

  1. Why is it that we seem to see bubbles so much when they were virtually unheard of 50 years ago. Too much market manipulation?

Leave a Reply

Your email address will not be published. Required fields are marked *